The debate about reforming the taxation rules of the principal residence exemption (PRE or the “Exemption”) has been revived recently. Under s.40(2)(b) of the Income Tax Act (“the Act”), a sale of a principal residence qualified as such under s.54 of the Act would result in an exempt portion of the capital gain ensuing the sale, up to the entire amount. It is a powerful rule. But there have been proposals to change the PRE rules, one being a home equity tax, which does not have an agreed-upon definition. This commentary assumes that a ‘home equity tax’ means capping or eliminating the amount of PRE.
Some argue that the policy reasons supporting the Exemption are strained. They may point at the uncapped amount, possibly millions in capital gains - the entirety of which a homeowner-seller may be able to shelter from tax. Was the rule designed to make the rich richer, especially considering capital gain is taxed at half rate, to begin with, and employment income is rarely exempt from tax? Further, in contrast with Canada’s generous PRE rules, in the US, the exempt amount of capital gain from a sale of a principal residence is capped at $250,000; also, unlike the ‘ordinarily inhabited’ requirement of a principal residence that is a source of litigation and subject of potential abuse, the US adopts a bright-line rule, requesting an accumulative 2 years of ownership of the residence within the last five years leading up to the sale.
Others would argue that PRE benefits most Canadians, regardless of the value of their home. Indeed, a dramatic change in the PRE rules will likely affect personal savings decisions and relevant real estate markets with possibly far-reaching changes for homeowners’ financial well-being and debt service on mortgages from financial institutions, in that debt services are subject to normal valuation changes on certain net proceeds for the purpose of retiring debt. Along this line, would symmetry require a balancing change to the recognition of debt service in computing taxable income and other related costs?
The far-reaching impact may extend beyond the real estate market to as far as state-administered social programs. If homeowners suffer a loss in disposable sale proceeds equal to home equity tax, and this affects their ability to provide for themselves financially including in retirement, would this create more fiscal demands, for example, to support programs to fill the gaps? Suppose there would be a transition from one regime to another, and based on our experience with V-day protocols and rules, is this paradigm shift likely to work well on such a widespread basis as would be required for owner-occupied housing? In short, the issue is wider and deeper than merely the PRE by itself and any review of the PRE rules would have to recognize these important considerations.
Despite the appeal, rules in another country are not necessarily transportable to the Canadian context (fiscal and tax). In fact, allowing only a portion of the capital gain to be exempt, as is the case in the US, puts a taxpayer-buyer looking for new homes with equivalent value as her previous residence in a situation where she has to downsize. What’s worse is to eliminate the Exemption, which could lead to a ‘lock-in’ effect, where homeowners simply do not sell their home knowing that they cannot afford another. Therefore, the elimination of PRE is arguably a severe blow to the real estate market – something that is not going to be politically palatable especially given the heavy punch COVID has already landed on the economy.
A dramatic change to PRE is likely to have a ripple effect on the fiscal, tax, financial and economic systems, which has to be carefully considered and calibrated. Ultimately, we need to ask this fundamental question: Would levying home equity tax help solve problems of the housing market? For those arguing for a capped exemption, why take issue with honestly accrued value of an expensive house – A house is a house, after all, or is it?
- Baiqing Luo (JD Candidate, OHLS Class of '21)