Promoting the Tax Free Savings Account for Homeownership

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1 Promoting the Tax Free Savings Account for Homeownership October, 2008

2 for Homeownership Prepared for: Canadian Home Builders Association Prepared by: 1580 Kingston Road Toronto Ontario M1N 1S2 Phone: (416) Fax: (416) altusgroup.com October, 2008

3 INTRODUCTION CHBA approached to provide the Association with an analysis on the role of savings in homeownership in Canada. Preparation of this study comes at a critical time. The painful adjustment in the U.S. housing market has forced policy makers to reevaluate certain homeownership savings initiatives. In addition to the Introduction, this report uses another five sections to provide a detailed analysis on this issue: The first section provides an argument for a more balanced housing policy framework; The next section examines some existing and previous homeownership saving programs; The next section analyzes certain saving programs aboard; The next section provides a summary of the new Tax Free Saving Account (TFSA) and its potential role of promoting savings for homeownership; and The final section offers some suggestions on promoting the use of the TFSA to encourage savings for homeownership. POLICY FRAMEWORK In light of emerging and evolving credit tightening conditions around the world and mounting evidence that highly leveraged homebuyers contributed to the severe U.S. housing market adjustment, recent economic events present a salient opportunity for Canadian policy makers to re examine the role of targeted homeownership related savings incentives. This paper is intended to foster and encourage further discussions among public policy makers on this important matter. In recent years, public housing policies have become progressively focused on increasing the accessibility and affordability of mortgage financing for potential homebuyers. The introduction of extended amortizations and low down payment plans supported by mortgage insurance has helped many Canadians become homeowners. While mortgage innovations certainly increase accessibility of homeownership, they also lead homeowners to become more highly for Homeownership Page 1

4 indebted for longer periods, and eventually increase financial risks for households and, ultimately, housing markets. A more balanced policy approach is required while governments should continue to reduce barriers that block people from reasonably accessing the mortgage market, public policy should also encourage households to save more for their home purchases, shoring up the equity portion of the underlying home. This reduces the chance of mortgage default and provides additional stability to the housing market. BACKGROUND Since the early 1990 s, growth in consumer expenditure in Canada has generally outstripped growth in personal income, resulting in a downward trend in the personal saving rate. In 2001, the household sector slipped into a deficit (net borrowing) position for the first time in Canadian history and this position has deteriorated sharply since (Figure 1). Figure 1 Net Lending*, Persons and Unincorporated Businesses Sector, Canada, Billions of Dollars * Net lending (borrowing) from households to (from) corporations and governments. Source: based on data from Statistics Canada, Financial Flow Accounts for Homeownership Page 2

5 The personal sector, which traditionally was a financier for the rest of the economy, now requires a substantial amount of external financing. 1 Thus, a well positioned policy that promotes saving is in urgent need. At the same time, there has been a rise in recent years in the number of home purchasers who are financing through high ratio mortgages. The popularity of high ratio financing is in part a reflection of the difficulty for some, particularly younger first time, buyers to raise in a timely manner a sufficient down payment for a conventional mortgage through savings. While lenders of high ratio financing are provided some protection through mandatory mortgage insurance in Canada, households are still at greater risk of default. Policy makers thus have an ideal opportunity to consider policies that help promote savings in general, while also accelerating the rate at which potential homebuyers can accumulate funds for larger down payments. A critical eye is used to distinguish between policies that promote savings thorough innovative mechanisms and by eliminating disincentives, rather than those that simply provide a subsidy to ownership housing. Some criteria to evaluate savings incentives policies are: Effective programs should avoid direct government cash subsidies to homeownership saving plans this will minimize the market distortion caused by the government direct subsidy; Efficient programs should be broadly available to all income groups this will maximize the benefits of the program; and Targeted programs should ideally have a single purpose this can minimize the conflicts between different saving programs and make it easier for homebuyers to track their saving goals. CURRENT AND PREVIOUS PROGRAMS IN CANADA Governments in Canada have a long history of promoting responsible homeownership through policies that encourage savings. This section presents some current and previous programs aimed at promoting savings and homeownership at both the federal and provincial levels in Canada. 1 Patrick O Hagan, Trends in Saving and Net Lending in the National Accounts, Statistics Canada, Catalogue No MIE No.049. for Homeownership Page 3

6 Due to accelerating real house prices in the 1970s that made it harder for young renters to save for home purchases, the Canadian government introduced the Registered Home Ownership Savings Plan (RHOSP), which provided households an opportunity to deduct from their taxable incomes when certain funds are set aside for a down payment on a qualifying home. (see Appendix). In general, programs that provide relief from taxation on down payment savings provide an efficient boost to younger, first time buyers as it accelerates the rate at which savings can be accumulated. In the case of RHOSP, there was no requirement for households to pay back this tax relief, so this scheme ultimately represented a modest subsidy measure. The program ended in 1985 with a tax reform measure. During its decadelong tenure, the program had a notable success according to an empirical analysis, in the 1970s and 1980s, the program increased the annual rate of transition from renting to owning for young renter households by some 20%. 2 In 1992, the government introduced the RRSP Home Buyers Plan (see Appendix) to assist homebuyers in saving for down payments. The RRSP Home Buyers Plan is under the RRSP program, which is primarily designed to promote retirement savings, and allows eligible home buyers to withdraw temporarily savings from their own RRSP accounts to help fund a down payment on a qualifying home purchase. Like the RHOSP, the Home Buyers Plan accelerates the process of saving for a down payment. As buyers are ultimately responsible for returning these funds to their registered plans, this scheme has a minimal ultimate cost to governments, while being very effective in promoting homeownership. Since its inception, the RRSP Home Buyers Plan has been used by some 1.3 million households, or one third of first time buyers. Withdrawals homebuyers have made from their RRSP accounts through the Plan have averaged nearly $10, Gary V. Engelhardt, Do Targeted Savings Incentives for Homeownership Work? The Canadian Experience, Journal of Housing Research, Vol. 8, Issue 2, CMHC, Home Buyers Plan Helps Turn Homeownership Dream into Reality, Housing Facts, Vol. 5, No. 4, April 2000 and Home Buyers Plan Helps Turn Homeownership Dream into Reality, CMHC News Release, March for Homeownership Page 4

7 While the Plan has been helpful in encouraging savings for the purposes of a first time home purchase, it does have its limitations. The $40,000 (maximum withdrawal permitted for a couple) under the RRSP Home Buyers Plan only accounts for about 13% of the average house price in Canada, far lower than the usual 20% down payment typically required for a conventional mortgage. The $40,000 funding limit has been in place since the creation of the plan in 1992, not indexed against overall inflation or housing price appreciation. Furthermore, the Plan requires homebuyers to repay the withdrawn money back to their accounts within 15 years. While this measure ensures that the plan has relatively minor negative effects on the RRSP s primary goal promoting savings for retirement it does have the effect of restricting a participating household s annual cash flow for many years. This reduces the debt servicing ability of homebuyers, potentially limiting room for mortgage payments. By contrast, the RHOSP did not require repayment of the withdrawn money as it was a pure homeownership savings account whose sole purpose was to finance a down payment. The RHOSP effectively gave homebuyers a tax break to save for first home purchase and the RRSP Home Buyers Plan just allowed homebuyers to borrow temporarily from their retirement savings. The RHOSP was a more efficient tool for homeownership savings than the RRSP Home Buyers Plan, but came at a higher cost to government. Homeownership savings programs have also been promoted from time to time at the provincial level. Ontario first introduced the Ontario Home Ownership Saving Plan (OHOSP) in 1988 (see Appendix) to help lowerincome first time homebuyers save for down payments. Similar programs were also introduced in Quebec and Nova Scotia. All these provincial programs have been terminated. The higher eligibility requirements limited Ontario s saving plan to only lower income and first time homebuyers 4. It was not a tool to encourage savings for homeownership for all income groups. 4 The OHOSP requires participants NEVER owned a home previously where as the RRSP Home Buyers Plan requires the participants have not owned a home for the last five years. for Homeownership Page 5

8 INTERNATIONAL EXPERIENCE AND POLICIES It is useful in developing a framework for the promotion of savings for homeownership, briefly to review experiences and policies in other countries. This section examines several savings incentive policies in place in other countries with an eye to evaluating effectiveness and applicability for Canada. The U.K. has a program called Individual Saving Accounts (ISAs) (see Appendix). The ISA is fairly similar to the Tax Free Saving Account (TFSA) that will be introduced in January 2009 in Canada, although the ISA places more restrictions on the classes of financial products that individuals can invest in within their accounts. Under the U.K. program, there are two types of ISAs: cash ISA and stocks & shares ISA. The program limits the amount invested in cash ISAs to half of an individual s annual contribution limit. The rest has to be invested in stocks & shares ISAs. The UK ISAs have an annual individual contribution limit of 7,200 (approximately CDN$14,800), which is substantially higher than the Canadian TFSA contribution limits. The Royal Institution of Chartered Surveyors in U.K. recently proposed a new saving program for homeownership, HomeBuy ISA, based on the existing ISA program. Some details of the proposed program are: The accounts would be available to anyone who has not previously owned a home and is resident in the U.K. In addition to the account holder, other people should be able to pay into the account including relatives and employers; The government should contribute 15% on the first 5,000 of individual contributions made each year; The program should work within the existing ISA structure to ensure it is exempt from income and capital gains tax. To encourage potential homebuyers to save as much as possible, the total annual ISA limit of 7,200 should be available; There should be a limit of 36,000 on the total amount that can be saved within an account; and Buyers should live in their new home for a minimum period of one year. for Homeownership Page 6

9 Other European countries such as France and Germany have programs that directly promote homeownership savings. Both the EL Home Saving Account in France and Bausparkassen in Germany (see Appendix) focus on building close relationships between mortgage lenders and homebuyers. Under both programs, potential homebuyers can open a special saving account with a mortgage provider (such as banks, credit institutions, building societies, etc.) and set up a saving target for their down payments. The interest paid on the savings might be lower than the market rate (but it has tax related benefits); however, homebuyers are also guaranteed a fixed rate mortgage and the access to the loan at the completion of the saving plan. Under the French home saving program, the maximum size of mortgage is tied to the Plan holderʹs accumulated saving and at the end of the saving phase, the homebuyer may receive a further subsidy in the form of a completion bonus. Under the German program, low income individuals are entitled to an annual government subsidy of 18% on savings up to a maximum amount. 5 Those policies help reduce the barriers for marginal households to the mortgage market since, in some cases, the amount of the loans are pre set. They also encourage savings for homeownership among potential homebuyers. These policies may also reduce constraints that prevent young households from entering the housing market. In general, German banks are relatively conservative compared to their Anglo Saxon counterparts and generally require 25 30% down payment for loans. Although the higher down payment requirements lower the risk of mortgage default, they can also prevent even modest income households from entering the ownership market. For young German households, the usual way to obtain enough down payment is a family loan or early inheritance. In 1997, only 46% of younger (aged under 50) couples in nuclear family households in Germany were homeowners: compared to 74% in Canada. 6 5 John R. Miron, Methods Used Abroad to Support Access to Homeownership: A Research Survey, CMHC, July John R. Miron, Methods Used Abroad to Support Access to Homeownership: A Research Survey, CMHC, July for Homeownership Page 7

10 After its initial introduction (following World War I), Bausparkassen significantly reduced the barriers to the mortgage market for ordinary Germans. The principal barriers during those turbulent times were high and volatile interest rates. 7 However, a more recent study, based on the data available in the 1970s and 1980s, concludes that the Bausparkassen system has not been successful in fostering homeownership in Germany; instead, it has mostly had the effect of increasing the size and quality of owneroccupied buildings. 8 France s program is more favourable for homebuyers the down payment, normally a minimum of 10% of house price, can be as low as 5% if the down payment comes from funds saved under the Plan. 9 The EL Plan has been popular among potential homebuyers, especially for young households in 1998, some 49% of year old French had one such plan. Nonetheless, these saving programs are most beneficial to homebuyers during particular economic times. For example, due to the guaranteed fixed interest rates, the ideal boost is obtained if the saving phase is during a period of low interest rates and the loan phase is during a period of high interest rates. The true value of such programs lies in their psychological impacts they encourage homebuyers to save for a generous down payment and help to enforce a life time budget constraint.these plans are means of enforcing self control, and should, ultimately, reduce mortgage defaults. Indeed, in Germany the mortgage default ratio is much lower than the Anglo Saxon countries, in particular the U.K. Australia s First Home Saver Accounts (FHSAs) program (see Appendix), which is designed to assist first time homebuyers to save for a down payment, allows participants to invest savings in their accounts for a wide array of financial products. The program combines tax breaks with direct government subsidies the Government will contribute 17 per cent on the first $5,000 (indexed) of individual contributions made each year and investment earnings (or interest) from the accounts will be taxed at a rate of 15 per cent. The maximum amount that an individual can contribute is 75,000 Australian dollars (150,000 Australian dollars for a couple) which represents 7 ibid 8 ibid 9 ibid for Homeownership Page 8

11 more than 32% 10 of the average housing price in Australia, significantly higher than the maximum withdrawal allowed under the RRSP Home Buyers Plan. The effectiveness of the plan has yet to be seen since the program was only introduced in July The Government of Australia believes that the program is going to boost the savings for homeownership in the country. Overall, several countries have policies aimed at encouraging household savings, either specifically aimed at homeownership or for general purposes. The main lessons for Canadian policy makers are: Contribution limits The $40,000 limit on the RRSP Home Buyers Plan appears to be relatively low compared to other countries. In other programs, home buyers are generally able to accumulate an adequate down payment for a conventional mortgage through these programs; Availability of the saving programs All the international programs examined above are made available to all income groups, although low income households might get additional direct government subsidies in some cases. Universality maximizes the impact of such programs on housing markets in those countries. Being universal, Canada s RRSP Home Buyers Plan is fairly consistent with these international programs; Self discipline for homeownership savings Some of these international programs have features that create self discipline among potential homebuyers for savings. For example, the Bausparkassen system requires participants to sign a contract that outlines the size of the potential mortgage at beginning of their plans. Under the contract, individuals have to save a certain portion of the mortgage before they are eligible for the loan. As a result, the program forces participants to save regularly for their mortgage down payments; and Single purpose homeownership saving program The programs from France, Germany and Australia, and RICS s proposed program in the U.K., are all designed specifically to foster homeownership related savings. Unlike, RRSP Home Buyers Plan, they are single 10 The ratio is calculated based on the contribution limit of a couple. for Homeownership Page 9

12 purpose saving programs. This allows potential homebuyers easily to track their savings goal and re enforce the saving habit for homeownership. Currently, the RRSP Home Buyers Plan is under the RRSP program whose primary goal is to promote savings for retirement. There may be some confusion or uncertainty in the minds of potential home buyers about the effects of Home Buyers Plan withdrawals on their retirement goals. This might be the factor contributing to the relatively low utilization of the program the average withdrawal from the plan has been close to $10,000, representing half of the permitted maximum amount. The RRSP Home Buyers Plan could become more effective if it were separated from the general RRSP program. THE TAX FREE SAVING ACCOUNT In the 2008 Federal budget, the Government of Canada introduced a new saving incentive scheme the Tax Free Saving Account (TFSA). This section analyzes the TFSA scheme and its potential role of as a vehicle to promote savings for homeownership by households. The following is a summary of the TFSA and its working mechanism: Starting in 2009, Canadians aged 18 and older can save up to $5,000 every year in a TFSA; Contributions to a TFSA will not be deductible for income tax purposes but investment income, including capital gains, earned in a TFSA will not be taxed, even when withdrawn; Canadians can withdraw funds from the TFSA at any time for any purpose; The amount withdrawn can be put back in the TFSA at a later date without reducing contribution room; and Neither income earned in a TFSA nor withdrawals will affect eligibility for federal income tested benefits and credits. CIBC economists project that Canadians will likely contribute some $20 billion to the TFSA in 2009 and the savings in TFSA accounts will reach $115 for Homeownership Page 10

13 billion by Those funds can be used to help potential homebuyers to finance their down payments. As discussed, the $40,000 funding limit on the RRSP Home Buyers Plan is only sufficient for a 13% down payment on a typical home in Canada. TFSA savings can certainly be a supplement to the existing plan for those households who have maxed out their RRSP Home Buyers Plan withdrawals. The TFSA, however, does not provide the same tax advantages as the RRSP Home Buyers Plan. It also lacks the focus on savings for homeownership in particular that a more targeted plan could offer. Funds saved in the account can be used for any purpose. A targeted TFSA that focuses on promoting savings for homeownership could include a tax saving incentive for participants who use the TFSA to save for a down payment. For example, the government could make the withdrawal tax deductible if it is used for the down payment of a home. PROMOTING THE TFSA TO SAVE FOR HOMEOWNERSHIP Programs that encourage savings can help to foster savings for homeownership. Canadian households already have access to a savings plan that promotes homeownership through the RRSP Home buyers Plan, but there is potential to use the new TFSA to further encourage a savings culture for homeownership in Canada: The government could add certain features to the new TFSA program to make it more favourable for homeownership savings such as taxdeductible withdrawals if used for a down payment on an eligible home purchase; and To introduce self discipline in homeownership savings, the government could consider a tax deduction for TFSA withdrawals based on a ladder rate that is, the more withdrawn for home buying the greater the tax break. For example, if the withdrawal is equal to 10% of the underlining house value, then, say, 50% of the withdrawal is tax deductible; if the ratio increases to 20% of the 11 Benjamin Tal, The New Tax Free Savings Account: How Popular Will It Be?, CIBC World Market, September, for Homeownership Page 11

14 house value, then all of the withdrawal is tax deductible. This formula could encourage participants to save for larger down payments and introduce self discipline in homeownership savings among homebuyers. Canada already has instruments that help Canadians save, and governments concerned with supporting homeownership could tweak these programs, especially the TFSA, to be more targeted and focused on the specific and important task of saving for the down payment on a home. for Homeownership Page 12

15 Appendix

16 CURRENT CANADIAN PROGRAMS RRSP HOME BUYERS PLAN Qualified buyers can withdraw a maximum of $20,000 individually or $40,000 as a couple from their RRSPs to purchase or build a house; To be qualified, the homebuyer must be a first time homebuyer the person has not owned a home which he/she occupied as his/her principal residence in the last five years; No income tax is deducted from these funds, as long as they are repaid to the RRSP over a period of no more than 15 years with the annual payment no less than 1/15 of the total withdrawal; and Since 1992, the program has been used by about 1 million or 1/3 of first time buyers. The withdrawals have averaged nearly $10, TAX FREE SAVING ACCOUNT (TFSA) Starting in 2009, Canadians aged 18 and older can save up to $5,000 every year in a TFSA; Contributions to a TFSA will not be deductible for income tax purposes but investment income, including capital gains, earned in a TFSA will not be taxed, even when withdrawn; Canadians can withdraw funds from the TFSA at any time for any purpose; The amount withdrawn can be put back in the TFSA at a later date without reducing contribution room; and Neither income earned in a TFSA nor withdrawals will affect eligibility for federal income tested benefits and credits. PAST CANADIAN PROGRAMS 12 CMHC, Home Buyers Plan Helps Turn Homeownership Dream into Reality, Housing Facts, Vol. 5, No. 4, April 2000 and Home Buyers Plan Helps Turn Homeownership Dream into Reality, CMHC News Release, March for Homeownership Page A 1

17 REGISTERED HOME OWNERSHIP SAVING PLAN (RHOSP) The program was introduced in 1974 and ended in a tax reform measure in 1985; Eligible individuals were allowed an annual tax deduction of up to $1,000 every year on savings committed to the purchases of a first home. Previous homeowners, persons who already owned real estate, and spouses of homeowners were not eligible for the program; Lifetime individual contributions were limited to $10,000 plus earnings and $20,000 plus earnings for couples; Funds in the accounts could be invested in a wide range of assets and could accrue for 20 years before withdrawal was required; Withdrawals could be made only once and had to be for the total accumulated amount in the account; and If the funds were used for home purchase, all accumulated contributions and earnings were exempt from taxation. ONTARIO HOME OWNERSHIP SAVING PLAN (OHOSP) The program was established to help lower income first time homebuyers in purchasing a home; The plan was available for individual earning less than $40,000 or couples jointly earning less than $80,000; The participants also had to be Ontario residents and 18 years or older, have NEVER owned an eligible home nor used OHOSP before; The participants could contribute up to $2,000 individually or $4,000 as a couple each year to the account, with the maximum tax credit of $500 per person or $1,000 per couple depending on the annual contribution and household income; The tax credits could be claimed in each of the first five calendar years of the plan. The funds had to be used and the plan had to be closed within seven years; If the fund was used for purchasing a first home, all withdrawals were tax free; By 2002, the program had been used by more than 250,000 homebuyers in Ontario; and for Homeownership Page A 2

18 The OHOSP program was terminated in the 2004 provincial budget. Two other similar programs in Quebec and Nova Scotia have also been terminated. INTERNATIONAL PROGRAMS INDIVIDUAL SAVING ACCOUNTS (ISA), U.K. With an ISA, UK residents can save up to 7,200 each year and pay no UK tax on the earnings from their investments; There are two kinds of ISAs: cash ISA and stocks & shares ISA; For cash ISAs, an individual can invest up to 3,600 a year, and can only invest with one service provider (i.e. banks, building societies, etc.) in any one tax year; For stocks and shares ISAs, an individual can invest up to 7,200 a year and can only invest with one service provider (i.e. banks, building societies, etc.) in any one tax year; If an individual wants to invest in both a cash ISA and a stocks & shares ISA in the same tax year, the separate limits for each type of ISA still apply, but the individual cannot invest more than 7,200 in total; No tax payable on the earnings from ISA savings and investments; Individuals can withdraw money at any time; and Individuals do not have to tell HM Revenue & Customs about income and capital gains from ISA savings and investments. EL HOME SAVING ACCOUNT, FRANCE The EL plan is to provide housing loans to persons who previously saved for this purpose and use the savings to finance their first home; The EL account constitutes of two plans: Compte d épargne logement (CEL) and Plan d épargne logement (PEL). In 1965, the EL plan began as CEL and was augmented in 1969 to include PEL. Whereas PEL is a fixed saving plan CEL is a more flexible saving account, since the amount to be saved is not fixed and withdrawals are allowed; With CEL, a household is entitled to a low interest mortgage loan after 18 months and a bonus of up to French Franc (FF) 7,500 depending on the for Homeownership Page A 3

19 amount saved (1999 conditions). As soon as a customer has signed a CEL or a PEL plan, the interest rate for both savings and mortgages are fixed; Interest earned on the savings is tax free; With PEL, households sign contracts to save fixed amounts for at least four years and PEL customers then have the right to borrow at a low mortgage rate with a bonus of up to FF 10,000 (1999 conditions); The interest paid on CEL deposits is lower than the interest paid on PEL deposits, which can be seen as the price CEL customers have to pay for having a more flexible plan; and The ratio of mortgage interest to savings determines the borrowing limit. CEL is better suited for buying a cheaper unit or financing a major repair, while the larger borrowing limit of PEL permits purchase of more expensive dwellings. BAUSPARKASSEN, GERMANY Bausparkassen is a popular savings program operated by the German building societies to help households to save for a down payment. This savings program is considered to play an important role in financing homeownership for low income households; A household that participates in the program saves a specific amount per month at a low interest rate until a predestined total savings amount is achieved; The household is then eligible for a predetermined loan at a low interest rate; and These savings are tax deductible or generate a tax credit (for low tomedium incomes). FIRST HOME SAVER ACCOUNTS (FHSAS), AUSTRALIA FHSAs provide a simple, tax effective way for Australians to save for their first home through a combination of Government contributions and low taxes; Australians who are aged 18 or over and under 65, and have not previously purchased or built a first home in which to live, are eligible to participate in the program; for Homeownership Page A 4

20 The Government will contribute 17 per cent on the first $5,000 (indexed) of individual contributions made each year and investment earnings (or interest) from the accounts will be taxed at a rate of 15 per cent; There is a limit of $75,000 (indexed) on the overall account balance; The account can remain open for as long as necessary or until the account holder turns 65, at which time it must be closed; To withdraw their funds, minimum contributions of $1,000 need to be made over the course of at least four separate financial years; Individuals are able to withdraw their account balance tax free to buy or build a first home in which to live; and The full amount has to be withdrawn and the account closed. for Homeownership Page A 5

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