The interesting history of capital gains tax in Canada — and its significant impact on real estate
Housing affordability is front and centre in the current federal election campaign, so much so that even policies that haven’t yet been announced — and may never have been destined for a platform — are courting controversy.
This week, the Conservatives accused the Liberals of harbouring a plan to impose capital gains tax on the proceeds from the sale of a principal residence, a charge the Liberals have flat out refuted. Currently, income generated from the sale of a principal residence is exempted fully from capital gains, and removing such an exemption would be no small matter.
With the issue in the spotlight again, we thought it was a good time to look back at the interesting history of the capital gains tax in Canada, and its particularly significant ramifications for the real estate market.
Brian Arnold and Tim Edgar, writing in the journal Canadian Public Policy, have defined capital gains as “gains realized on the disposition of property to the extent that they are not otherwise required to be included in income.”
The capital gains tax in Canada was implemented in 1972. The Royal Commission on Taxation, led by Kenneth Carter, had earlier recommended that since capital gains, gifts and bequests improved the welfare of the fortunate recipients, such gains must be taxed like income and wages. ‘A buck is a buck,’ the Commission famously argued.
As a result, changes were made to the Income Tax Act, and 50 per cent of all realized capital gains were included in taxable income. Over the years, the inclusion rate rose from 50 per cent to 66.66 per cent and then to 75 per cent, before being reduced back to 50 per cent, where it stands today.
Interestingly, Arnold and Edgar noted that the implementation of capital gains tax has been “strikingly similar in some respects but very different in others” when compared with tax implementations in Australia, New Zealand, the U.K. and the U.S. Except for New Zealand, where no general capital gains tax is implemented on local investments, the remaining economies have implemented very similar capital gains taxes.
A comprehensive capital gains tax in the U.K. was introduced in 1965. Australia introduced a similar tax later in 1985. The experience in the U.S. is more mixed where capital gains and changes to the highest marginal tax rate have been proposed in a series of changes including the Tax Reform Act of 1986. The Act included capital gains in income “in full; in return, the maximum marginal rate of tax for individuals was lowered substantially.”
What is also common among the countries with capital gains tax is the exclusion of gains on the sale of the principal residence. The U.S. regulations differ slightly as they are more restrictive. In Australia, in addition to the principal residence, up to two hectares of the surrounding land may qualify for the exemption. Canada exempts 0.5 hectares of the surrounding land.
“The exemption of these gains reflects the political sensitivity and social significance of the family home,” noted Professor Arnold and Edgar.
The recent campaign controversy suggests that inclusion of the principal residence in capital gains remains a hot button topic.
Three-quarters of Canada’s national wealth is real estate and principal residences constitute a large part of that. A tax on the proceeds of principal residence sales would directly hit homeowners who, for decades, have shifted savings from other investment vehicles to their homes. A new tax would also inadvertently hurt residential real estate markets, which in turn would impact domestic consumption.
With the majority of Canadian households (68 per cent) being homeowners, anything that adversely affects their wealth would be unlikely to help in an election campaign.
The exemption of these gains reflects the political sensitivity and social significance of the family home
Brian Arnold and Tim Edgar
The Canadian implementation of the tax differs from the rest in two key aspects. First is the introduction in 1985 of the lifetime capital gains exemption, which since 1995 can only be used by small businesses, farmers and others involved in the fisheries.
The second key difference, as pointed out by François Vaillancourt and Anna Kerkhoff in a recent article in the eJournal of Tax Research, is the “failure of capital gains taxes in Canada to account for inflation…. Because the initial capital cost is not indexed for inflation, those paying the tax on realized gains are paying taxes on an increased value owing partially or entirely to inflation and not to an increase in the real value of the asset.”
In contrast, Australia, the U.K., and the U.S. have introduced indexation allowances to address the adverse impact of inflation on capital gains. Australia implemented indexation in 1985, three years after the U.K. did the same.
Ignoring inflation in capital gains is partially the reason why the supply of purpose-built rental construction disappeared almost entirely in Canada.
Though many have connected the severe decline in purpose-built rental construction with the introduction of vacancy decontrol (rent control) in the seventies, the fact remains that rental construction started to decline drastically with the introduction of a capital gains tax that did not account for inflation when it came time to sell.
Purpose-built rental supply in Canada has not recovered to the levels seen before the implementation of the capital gains tax.
Instead of contemplating a broader capital gains tax, the reverse is needed. Those contesting the October election have an opportunity to include progressive provisions in their platforms that are likely to improve the welfare of Canadians.
Accounting for inflation in capital gains would be one way to encourage investors to reconsider participating in purpose-built rental construction, which in turn could help ease tight vacancy rates and the growing pressure on rents.
Murtaza Haider is a professor of Real Estate Management at Ryerson University. Stephen Moranis is a real estate industry veteran. They can be reached at www.hmbulletin.com.