Welcome to this month’s installment of Dear Urbaneer, where I counsel clients and customers on their real estate related queries. This month, I am helping a prospective property investor who is wondering about ROI in the context of the new CRA taxation requirements, intending to deter shadow-flipping and speculative investment.
I found your post Dear Urbaneer: How Might CRA Taxation Affect The ROI Of An Investment Property? super helpful when I started researching property investment. While I’m hesitant to jump into the market right now given the frequent and sizeable hikes in interest rates, I also want to be prepared in case the right opportunity presents itself; I’m seeing many properties being sold under ‘Power of Sale’ lately, which could represent potential opportunities for me. In addition to the Bank of Canada’s interest rate hikes, the new CRA anti-flipping legislation will likely affect my potential ROI too, right? But how, and what do I have to know?
Profitable Property Perusing
Here’s my reply:
Dear Profitable Property:
First, from your letter, it appears you’re already taking the right first steps toward property investment. Regardless of the market conditions, the optimal way to maximize your potential ROI is to begin by systematically researching all the ABCs of property investment.
Next, you might consider seeking out some relevant online interest groups, such as ‘r/OntarioLandlord’ on Reddit which caters to both landlords and tenants, and ‘SOLO’ (Small Ownership Landlords Of Ontario), where you can ask questions and follow the experiences of other landlords (like the nightmares property owners are having with the Landlord Tenant Board where it’s taking 8 months+ to schedule a hearing – all while their tenants are not paying rent!)
I also believe it would serve you to start meeting and interviewing
credible qualified experts familiar with the type of properties you’re considering purchasing as an investment. This might include a lawyer, an accountant, a realtor, a property manager, a handyman or contractor, and even a design expert versed in economical tricks and tips to ensure your property is fresh, on-trend, and will garner the highest possible rent.
Always carefully consider your options in the context of your current real estate goals and those you hope to achieve in the future. Real estate investment is a long game, meaning that once you intelligently select and secure a property you should never sell it for 2 or 3 decades. Now I recognize there are all sorts of extenuating circumstances that might cause someone to sell an investment property sooner, but what I mean by this is that to sell one investment property after five years to buy another because you prefer it, or it’s closer to where you live etc, may be well and dandy, but it also costs you money to do it. And an investment property purchase is not supposed to cost you, ok? And just to be clear, to sell an $800,000 condo (realtor fees, mortgage fees, lawyer fees) and buy another one for the same price (double land transfer taxes, appraisal fees, lawyer fees) is an out-of-pocket expense of about $70,000 (or more if you have to pay your tenant to vacate). Which is a lot of money, right?
And please never fall into FOMO – the Fear Of Missing Out – and act on an investment property purchase before you’ve completed all of your due diligence. Property investment is prudent and pragmatic. There is no room for desire to cloud your judgment, even though I do believe you should only purchase properties that you like (or love) that complement you. This is because I personally believe Pride of Ownership is essential to being a good landlord. After all, how can you expect your tenants to invest their time in taking care of your property if you don’t?
If you own real estate and you have existing debt registered against its title, whether it’s a variable mortgage with a trigger rate, a HELOC, or even a fixed mortgage that is coming up for renewal imminently, you may or will soon be feeling the effects of a significant 450 basis point jump in interest rates by the Bank of Canada since March 2022. This translates into a 5-year fixed mortgage being around 3% higher than what you could have secured a year ago in February 2022 which means everyone, including property investors, will be feeling the crunch and seriously erode some of your Return On Investment. In addition to rising interest rates making property investment more expensive, taxation is another real cost that could certainly eat away at your bottom line. With the introduction of a new tax that is meant to deter house flippers and speculative investment, there are new considerations for property investors
As a side note, this is a good lesson in real-time, not to base your hopes on ROI on rising property prices. While it is true that real estate does almost always gain value over the long term, in the short term, this asset is illiquid and is very vulnerable to market fluctuation and interest rates putting the squeeze on margins.
That’s why two basic principles in property investing should always be adhered to: buy and hold for the long term- and keep your property investment cap rate at such a level to permit healthy cash flow to mitigate market risks.
But back to your question: How might the new tax rules potentially impact your property investment?
Here Comes A New Tax To Deter Flippers
Last summer, the federal government tabled draft legislation intended to curb speculation in the property market. At issue is the role of speculative investors who are buying up properties (particularly in Toronto), renovating them in short order (or adding lipstick on a pig as the case may be), and reselling them while claiming they were simply buying and selling a principal residence. Rather than renovating and reselling dwellings as a business (and filing taxes accordingly), they’re masking their actions and claiming the sale as a tax-free gain.
This practice negatively impacts affordability in a number of ways. First, these investors are removing properties from the hands of would-be end users, who are seeking homes primarily for shelter and secondarily for investment purposes (by building equity). Second, more Buyers means more competition which effectively drives prices up.
Although there are Mom & Pop flippers who take this route to fast-track their climb up the property ladder (still not legal), the flipping industry can be quite sophisticated. Established institutional investors (like REITs) may purchase dozens if not hundreds of dwellings that they’ll convert into illegal multi-unit dwellings that they subsequently rent (so while they’re not reselling the dwellings immediately, they’re still purchasing fixer uppers and investing capital to serve their quest for profit). Foreign investors also play an active role in the flipping game. A few years back in Little Italy, there was a group of Chinese construction workers operating as a crew on a series of renovations and new builds. They had been flown in from China for the sole purpose of working for this fellow who didn’t appear to be abiding by any labour laws, given they worked every day. And I have to say the workmanship was far from ideal. The reality is that the pockets of these Buyer profiles are much deeper, meaning that they can and do pay top dollar for dwellings. And they also cut corners and lack Pride of Ownership, because their sole motivation is profit. This in turn jacks up housing prices, eroding affordability further for homebuyers seeking to purchase homes for personal use. And it leaves the Buyers of these flips having to incur significant expenses fixing the poor quality workmanship.
I wrote about this phenomenon in The Number Of Owners With Multiple Properties Is Increasing In Toronto. Here’s Why! and The Growing Trend Of Financial Landlords In Toronto Real Estate.
The Nuts & Bolts Of The New Anti-Flipping Tax
Proposed last summer, this new tax came into effect this past January. The new tax targets homebuyers who hold their properties for short periods.
When an investor sells their income property, any asset growth realized between the purchase price and the sale price is realized as capital gains. Capital gains are taxed at 50% – which is less than straight business earnings or income – making it more favourable.
However, if the dwelling is occupied by the owner as their principal residence, the homeowner may be exempted from paying any tax on the sale under the Principal Residence Exemption (PRE). To qualify for the PRE, the homeowner must live in the home for part of the year (or their spouse, common-law partner, or child). And a homeowner can only designate one property as a principal residence.
The real distinction lies in properties that generate income versus being occupied as a principal residence. Beyond generating rental income, which is obviously taxed as regular income, if a dwelling has been purchased for the purpose of flipping, or newly constructed and listed for sale, or bought preconstruction with the objective of selling it prior to completion as an assignment, and profits realized from these are taxed as income (generally at the highest rate).
And, under this context, is the new anti-flipping CRA rule. At the moment, what qualifies as a “flipped property” is a little vague, but what seems to be most pressing to Revenue Canada is the timeline between the purchase of the property and its resale date. And if the property has been owned for a period of less than 365 days, then Revenue Canada is likely going to do some further investigation to ask the owners questions, particularly if there is a substantial difference between the acquisition price and the resale value.
Additionally, under consideration would be the motivation that prompted the Seller to dispose of the property, and what business they are in (i.e. are they a builder/developer, contractor, architect, designer, or professional property investor). Basically, the more likely you’re operating somewhere in the realm of the Shelter Industry, the more likely the CRA will hold these sales to the new taxation.
This article has great background Flipping A House? Your Gain Could Be Fully Taxable Under This New Rule.
There are always exceptions to most rules, and in this case, it mostly hinges on life events that might precipitate the sale of a home in short order, like the death of the homeowner or one of their family members, a marriage breakdown, a change in household status that might require a change to the living arrangements (i.e. the birth of a child, elderly parents or other dependants moving in for care etc.), disability or illness of the homeowner, relocation of the homeowner or their spouse for work purposes, insolvency and so on.
In short, there are real-life reasons that arise that might compel an owner to sell their home shortly after they buy it, and in reasonable circumstances, the Anti-Flipping Tax wouldn’t apply. However, homeowners should be prepared to demonstrate any of these exemption possibilities to the CRA with documented proof.
What’s At Stake?
Property investors should take heed of the hefty penalties, should they decide to skip reporting on a property sale as business income under the criteria established under the Anti-Flipping rules. The homeowner could be charged a gross negligence penalty which could be up to another 50 percent on top of the taxes owing, plus interest accrued. That’s significant.
For more detail about non-compliance, check out this link to the web page by the CRA called How The Canada Revenue Avenue Addresses Non-Compliance In The Real Estate Sector
Toronto developers have enjoyed several decades of launching their condominium projects to the market offering investors pre-construction prices with the right to assign the sale to another Buyer at any time for a nominal fee. Given the typical length of time to launch a proposed condo and see it completed and registered as a condominium corporation can take anywhere from three to five years, the resale value of these paper contracts has tended to rise substantially, particularly over the past 8 years. As original Buyers realized they could earn tremendous profits for simply signing and reselling their real estate contract ‘on assignment’ to a new Buyer before the development was completed, it fueled more speculators to embrace this easy money approach, allowing them to pocket a cash profit quietly and, until recently, without Revenue Canada’s knowledge. Why? Because the real estate sale does not require an actual transfer of title on Land Registry, it was easy to hide. Because of this, it became a common practice.
However, Sellers of assignments should take note that the profits from these sales are considered taxable income which has now been set out in the federal government’s 2022 budget. Furthermore, what has long been ignored is now a legal requirement. Anyone assigning a condo that has not yet been registered as part of a condominium corporation will now have to collect and remit GST/HST from their Buyer. Prior to these new rules, GST/HST on assignments was only applied if the Seller was a real estate professional/company/entity. Now, all sellers are obliged to comply and are subject as well.
Second, assignment sales are also subject to the Anti-Flipping tax as well, with all profits treated as 100 percent taxable income, unless the Seller can prove intent under one of the aforementioned exemptions for the anti-flipping tax. Want to learn more? This is a helpful post, Real Estate Assignment Sales – New Tax Rules as is this one Tax Implications Of A Real Estate Assignment: A Tax Exposure Calculator.
An Aggressive Stance From The CRA
Reportedly, the CRA means business with this new tax, as they wasted no time challenging sale dispositions from Sellers that might have been perceived as “flipping”, taking some Sellers to court last fall.
According to this Financial Post article, The CRA Is Already Challenging Real Estate Transactions Ahead Of New Anti-Flipping Rules.
What this demonstrates is that, although criteria are set, there is some ambiguity. For example, in the FP article, a case is discussed where the CRA challenged a claim from a seller who stated her home was a principal residence because she sought refuge there frequently from an abusive partner, from whom she eventually divorced. She lived there on and off, reportedly.
The CRA disagreed, calling it an” adventure in the nature of trade” and saying that the evidence suggested otherwise (i.e. the homeowner never changed any addresses to reflect this being her primary residence, and she had purchased and extensively reconstructed the property, selling it in short succession).
The courts found that while they don’t believe that that home was acquired for the purposes of flipping (i.e. she was a teacher as opposed to a real estate professional;/builder/contractor), they did feel that evidence presented was insufficient to suggest that this home would have qualified as a primary residence.
Furthermore, the court found that this homeowner would not be responsible for the gross negligence penalties, as she did not seem to be properly aware of the taxation rules, beyond treating profits of the sale of the home as taxable income. So a good news/bad news scenario for this homeowner.
Government Bans Foreign Buyers
The Anti-Flipping tax isn’t the only measure that the federal government is taking to try to curb speculative investment and the impacts on housing supply and affordability.
This past January, a ban on foreign buyers came into effect for the next two years. Non-residents will be prohibited from purchasing dwellings having three units or less in the hopes this intervention reduces the pool of active Buyers that would otherwise be competing with end users (Multi-unit buildings and recreational properties are exempt). This ban has solicited mixed reactions, as there are loopholes and exemptions as I wrote in Shades Of Duplicity In The Foreign Buyer Tax For Canadian Housing. For example, international students (with conditions) are exempt, as are foreign residents with temporary status and others as well. This CBC article Canada’s ban on foreign property buyers won’t apply to many workers, international students provides good background on those exemptions. However, this ban could be ill-timed, given Toronto will see the delivery of 32,000 new condominiums this year alone, and rising interest rates have put many investors in a precarious position. For more details, check out my post –> Is The Toronto Condo Market In A Precarious State?
When it comes to property investing, it’s all about your timeline. While flipping a property may seem like an attractive idea thanks to HGTV who have done a great job misleading viewers that flipping is quick, easy, and hugely profitable under the guise of ‘entertainment’, as I share in Behold The HGTV Effect On Toronto Real Estate. As I wrote in Dear Urbaneer: How Much Profit Should I Expect Climbing The Property Ladder?, your property purchase has to increase about 7 percent just to recover your buying and selling costs in Toronto, and that’s not including the time, energy and capital you may have invested simply moving in and making the space your own. The introduction of this new Anti-flipping tax makes this even more relevant. Needless to say, in these changing times, as Revenue Canada applies more scrutiny to the exchange of real estate, it’s wise to consult with your realtor and your accountant prior to purchasing a property investment to make sure the costs and benefits align with your real estate goals.
With a cautious, measured approach to property investing, based on strategy and an eye to the future, we are here to help!
If you enjoyed this blog, you may find these posts helpful and interesting:
Turning A Blind Eye To The Real Costs Of Toronto Real Estate Investment Properties
Dear Urbaneer: For Toronto Property Investors, What Are The Pitfalls Of Buying Older Dwellings?
Is The Toronto Condo Market In A Precarious State?
Topsy Turvy: Insights From The Toronto Real Estate Trenches
Rising Interest Rates And The Toronto Real Estate Market
How Canada’s 3 Levels Of Government Shape Housing Policy & Programs
5 Essentials For Toronto Real Estate Investment
The Number Of Owners With Multiple Properties Is Increasing In Toronto. Here’s Why!
Shades Of Duplicity In The Foreign Buyer Tax For Canadian Housing
The Growing Trend Of Financial Landlords In Toronto Real Estate
Toronto Real Estate: Are You Investing Or Speculating?
What Do Property Investors Dream About?
How To Navigate Renting Your Toronto Investment Property
Can I Have An Income Suite In My Residence?
The Other Side Of Rent Control And Toronto Real Estate
Dear Urbaneer: What Are The Closing Costs For A Property Purchase?
When Dreams Of Domesticity Became Nightmares: A Recollection Of The 1989 Toronto Housing Market Crash
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