The Wholesale-Retail Rental Housing Split, Tax Forgiveness on Rollover and Implications for Tenants
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1 The Wholesale-Retail Rental Housing Split, Tax Forgiveness on Rollover and Implications for Tenants By Marion Steele Department of Economics, University of Guelph and Centre for Urban and Community Studies University of Toronto Many thanks to F. Des Rosiers for his spreadsheets used as the basis of simulations in this paper.
2 Introduction The Conservative tax proposal: Eliminate capital gains tax when an asset is sold if the proceeds are reinvested within six months so tax forgiveness on rollover Rationale: to end lock-in To analyze this, first Retail wholesale split in the rental housing market Rented condos & other small properties vs Large, wholly rental buildings Show here Retail pay less tax during holding years (regressive?) Exacerbated by tax proposal Lock-in desirable for tenants
3 Next Distinguishing characteristics of retail rental housing Prices and rents in retail vs wholesale The role of the Capital Cost Allowance (CCA) and capital gains taxes Leverage and the deductibility of interest expense Simulations showing taxes paid currently by retail and wholesale rental housing in Toronto For investors who hold for 20 years and for those who hold for just 5 In rational and irrationally exuberant market Show tax forgiveness on rollover regressive among tenants Argue tenants better off if lower turnover
4 Crucial differences between retail and wholesale rental housing Tenure elasticity in retail: easy switch between owneroccupiers and renters Good for investors allows selling wherever the price is better, homeowner or investor market Not good for tenants -- security of tenure problem Price per housing unit much higher in retail than in wholesale market tenure elasticity economies of scale
5 Prices, rents, leverage Toronto 2 bedroom apt, Price Rent condo $220,000 $1,487 wholesale (per unit, multi-unit bldg $90,000 $1,067 Price-to-rent ratio (annual rent ) condo 12.3 wholesale 7.02 Condo buyers must be expecting much higher capital gain. High leverage possible, especially for retail Wholesale buyers can make 15% downpayment using NHA-insured mortgage Retail buyers can use PLC loan, say 20% of price, get 75% uninsured mortgage, so equity of just 5% is possible
6 Three features of the tax system The Capital Cost Allowance (CCA): excessive deduction for depreciation For individual investors already holding profit-making real estate, a loss can be created or increased by CCA so possible to get tax deduction even when property is profitable For other individual investors CCA can reduce net rental income to zero Only half of capital gain is counted as income, so capital gain is tax-advantaged. Only taxed when property is sold (or..). Interest is fully deductible. If, because of this there is a rental income loss, full deduction of this against other income, e.g. surgeon s income from surgery. Surgeon can make a loss (and deduct it) for 5 years and then sell and pay capital gains tax at half income tax rates. [REOP now seems for all intents and purposes legally dead]
7 Assumptions for 20 years of holding wholesale apartment property Rate of inflation, 2% -- increase in building price, 2% -- increase in price of land, 3% Land is 25% of value of property, so value of property rises by 2.25% per year Rent rises by 2.25% per year Capital expenditure 5% of indexed value of building every five years to offset physical depreciation of 1% per year (device from Miller and Geltner) Mortgage amortization term, 40 years Investor in top tax bracket (46% ) in Ontario These assumptions give a Debt Coverage Ratio (=Net Operating Income as a ratio of debt service) of 1.62 What happens to cash flow before taxes, and taxes paid each year, as rent rises?
8 Wholesale apartment, Toronto, long (20 year) hold $10,000 $8,000 $6,000 $4,000 $2,000 $ Cash flow from operations, after financing Interest Capital Cost Allowance Income Tax:
9 Assumptions for rational condo case Inflation, rate of building price increase, as before Land is only 15% of value of property, so value of property rises by 2.15% per year Rent also rises by 2.15% Mortgage amortization term only 25 years, but 20% of initial price is borrowed from PLC with no amortization Underlying assumption is that investor is a homeowner with large home equity and has prime-rate PLC These assumptions give a Debt Coverage Ratio of only 0.96 (based on mortgage payment, i.e. excluding interest on PLC debt) What happens to cash flow and taxes paid each year, as rent rises, is shown next
10 Condo apartment, Toronto, long hold $15,000 $10,000 $5,000 $0 -$5, Year Cash flow, from op, after financing Interest Capital Consumption Allow ance Income tax paid
11 The condo investor in an irrationally exuberant market Recall: observed current prices and rents make sense only if investors assume a high rate of capital gain Assume rate of inflation is still 2% And rent still rises by 2.15% BUT investors observe the owner-occupier market rising quickly and assume they will sell into that market. So, assume building price rises at 6% (4% real) price of land rises at 10% (8% real) so value of property rises by 6.6% per year
12 Taxes paid, first short hold $14,000 $12,000 $10,000 $8,000 $6,000 $4,000 $2,000 $0 -$2,000 Tax paid prior to sale (NPV) Tax paid at sale (NPV) Total tax (NPV) Wholesale Condo, irrationally exuberant case Present value of taxes paid by condo higher it has bigger capital gain But condo investor pays essentially no tax during hold
13 Taxes paid, four successive short holds $60,000 $40,000 $20,000 $0 Wholesale -$20,000 -$40,000 Tax paid prior to sale (NPV) Tax paid at sale (NPV) Total tax (NPV) Condo, irrationally exuberant case Taxes paid when property held by various investors over 20 years shows tax deduction condo owners get during hold. If expectations are not realized, then tax at sale may not offset this.
14 Effect of tax forgiveness on rollover $60,000 $50,000 $40,000 $30,000 $20,000 $10,000 $0 Tax at sale, Tax at sale, current no cg system tax (NPV) (NPV) Total tax, current system (NPV) Total tax, no cg tax (NPV) Wholesale, long hold 4xcondo,short hold This shows that tax forgiveness on rollover does not greatly reduce taxes paid by wholesale apartment held for 20 years, but brings huge reduction in taxes for condo held for 5 years. Short-holds are encouraged, and short-hold condos are encouraged even more
15 Lock-in The rationale for eliminating the capital gains tax on rollover Refers to situation where an investor is locked into an investment because of taxes due on sale From the Ontario Government s Housing Supply Working Group Interim Report, 2001 It is recommended that particular attention be paid to the ability to rollover capital gains tax.. (and the amount of allowable CCA deduction). (p.31) From Pomeroy and Lambert (for Ontario MMAH, 2002) This would be beneficial to investment in new rental projects since it would encourage owners of older, heavily depreciated properties to upgrade their rental property portfolios by replacing older projects with newer ones. (p. 26)
16 Lock-in occurs because The investment has been a profitable one Without capital gains, there would be no capital gains taxes The CCA taken has been economically unjustified So on sale investor must pay tax on, roughly, the cumulated CCA taken
17 Evidence on its importance Gau and Wang (1994) found among investors in apartments in Vancouver, an average holding period of only five years. Cruder, more recent evidence for all Canada suggests the holding period is now not much longer. Data are from Canada Revenue Agency s Income Statistics for 2004 tax year The number of landlords is the number reporting net rental income (positive or negative) Number of landlords divided by number reporting capital gain or loss for real estate gives crude estimate of holding period
18 I Estimate of holding period, about 2004 Taxfilers with property gain or loss (%) Landlords Ratio to those having real property gain or loss % of Income taxfilers 0 to $40K >$40K All Holding period indicated to be about 7 years. Holding period of those with income over $40K indicated to be less.
19 Tax forgiveness on rollover good for tenants? Will it reduce rent? A reduction of tax on investors in rental housing tends to help tenants to the extent that it is passed on to renters. Will tend to be passed on if supply curve is elastic But many landlords are in low tax brackets -- see previous table and Wood and Tu (2004) -- and these tend to be the landlords at the margin. So Likely much of tax saving to highest bracket investors will not be passed on. Tax saving to condos greater than tax saving to wholesale rental housing investors. Conclude: will tend to reduce rent, but effect may be very small. Will tend to help richer tenants the most because they tend to occupy condos.
20 Will it reduce security of tenure? Almost certainly, because it encourages Investment in tenure-elastic retail units Short holds How important is security of tenure? Knetsch found tenants not willing to move unless compensated with thousands of dollars Aaronson (2000) found child outcomes very damaged by mobility. Dominant reason children of renters have worse outcomes than owners children is greater mobility.
21 Concluding remarks Tax changes should be introduced to end the unfairly light taxation of the retail rental apartment sector (relative to the wholesale rental apartment sector) Tax forgiveness on rollover is not an effective way to help renters, especially low income renters. Current soft rental market (in Toronto) shows increased private investment not needed. May be needed in Vancouver and Calgary. Other ways of helping renters more equitable
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