Looming changes to Canada’s capital gains tax will have the most immediate implications for private real estate investors who were in the process of divesting properties when the federal government announced its intentions in the 2024 budget, released on April 16. In the longer term, it’s expected that the jump from a 50 to 66 per cent inclusion rate, which takes effect on June 25, will be factored into a range of asset management and investment decisions.
Regardless, some of the most prominent players in the Canadian commercial real estate market won’t incur direct fallout since pension funds are exempt from capital gains tax. Nor is the tax applicable on deals that render a loss on the seller’s acquisition costs so many insolvency-triggered offerings in the marketplace won’t be affected.
For corporate property owners, the new capital gains inclusion rate means that 66 per cent of the realized profits from a sale — i.e. the gain above original acquisition costs — will be added to their taxable income for the year. A more moderate two-step formula will be applied to non-incorporated individuals who sell investment properties,. They will be taxed on 50 per cent of capital gains up to $250,000 and then on 66 per cent of the remainder of their profits.
“If you’re a private investor subject to the capital gains tax, based on our initial quick calculation, the new inclusion rate probably adds anywhere between 8 and 12 per cent to your cost, depending on your tax bracket,” Mark Sinnett, executive vice president of capital markets with Avison Young, told webinar attendees last week.
Yet, it’s not clear if commercial real estate will be a big booster of government revenues in the near term. Transaction volume has dropped significantly since early 2022, linked to uncertainties around financing costs, prospects for returns and an often unnegotiable gap between vendors’ and would-be purchasers’ expectations. Speaking during the same webinar, Amy Erixon, Avison Young’s president, investment management, noted that institutional investors have been among the most active sellers in this low-activity period, as they seek to shift their asset allocation away from office properties and/or cash out holdings to then reinvest in new development.
“The capital gains tax change is so recent, we haven’t had a chance to see what the market’s reaction is going to be,” she observed. “A lot of the sales that are going on are from tax-exempt pension funds so it’s sort of irrelevant to the amount of property that’s coming to the market. Private sellers are a very small piece of the market currently.”
June 25th deadline could work in buyers’ favour
Other industry insiders see June 25 as a formidable deadline that may work in buyers’ favour with vendors who are aiming to realize their profits before the inclusion rate rises. Depending on the tax implications, more sellers may opt to lower their prices in order to get deals done and/or offer attractive vendor take-back financing if they’re in a position to do so.
“The banks are only lending 45 to 55 per cent on apartments now and it takes three to six months, if you’re lucky, to get approved for financing,” says Lorenzo DiGianfelice, owner and broker of record with Commercial Focus Realty Inc., specializing in multi-residential transactions. “I have clients who want their properties moved ASAP due to the (capital gains) announcement, and they will take a first mortgage vendor take-back for a year so a buyer can get financing later.”
“The bid-ask gap, the difference between buyer and seller expectations, is the reason we’re seeing less investment activity and some properties on the market for a long period of time. So it’s going to be challenging for anyone who’s in the position of having to sell for a certain reason,” predicts Raymond Wong, vice president of Altus Group’s data and research division. “If you throw in the tension of this time factor, buyers are going to ask for a further discount.”
Once the new inclusion rate comes into effect, DiGianfelice foresees there will be more manoeuvrability within larger portfolios to find offsetting capital losses, while small-scale owners of low-rise multi-residential buildings or investment condominium units could be more exposed. Adding to the blow, incorporation will effectively add an extra $40,000 to their taxable incomes when they realize upwards of $250,000 in capital gains (or a prorated differential for lower amounts of profit) versus owning the property as an individual.
“The larger landlords have top accountants and tax planning advisors to figure out all this stuff; the smaller mom-and-pops do not,” DiGianfelice submits. “Most small landlords have put their buildings in a corporation and that’s going to hurt them now.”
Alternatively, vendors may begin to proactively account for higher tax costs. “We suspect we’re going to see pricing that somewhat reflects that. It will just get priced in. That’s, unfortunately, an unintended consequence,” Sinnett hypothesized.
Pondering the impact on competitiveness
There is also trepidation the pullback on capital gains could generally inhibit real estate investment, undermine key office tenancies and disadvantage REIT unit-holders versus stock shareholders. While citing Canada’s many competitive strengths — solid real estate fundamentals, lower labour costs than in the U.S. and a steadier economy with less geopolitical upheaval than much of the G20 — industry players nevertheless express concern that foreign investors could be put off.
“Last year, five of the top 10 investment transactions for real estate involved foreign buyers. They are coming to Canada because of the stability,” Wong reports. “The question is whether this capital gains tax will deter them from further investment. Any time you add another factor to the issue when you’re trying to compare where to invest — what country or asset type — that plays into it.”
Wariness in other industry sectors could likewise filter down to commercial real estate. “If tech activity and demand is dampened due to entrepreneurs looking to the U.S. instead of Canada, this would reduce demand for office leasing in particular,” CBRE Canada chair, Paul Morassutti, stated in a recent blog.
The 2024 budget documents presents the capital gains adjustment as a move to better equalize the marginal tax rate across the Canadian population and to generate an additional $19.4 billion in federal revenue over five years. Parsing out the tax-paying profile of more than 2.4 million Canadian corporations, the budget document shows that about 307,000 or 12.6 per cent registered net capital gains in 2022. This group posted average taxable income of $702,000 versus an average of $174,000 across more than 2.1 million, or 87.4 per cent of corporations with no capital gains.
The budget document projects that Canada’s marginal effective tax rate (METR) — representing the average level of business taxation when accounting for federal and provincial/territorial tax, investment tax credits and capital cost allowances — will continue to be the lowest among G7 nations out to 2028, and will also be lower than the average for the other 37 nations in the Organisation for Economic Co-operation and Development (OECD).
It pegs Canada’s METR at 14.5 per cent for 2024 and projects it will rise to 16.8 per cent by 2028. Looking south, the U.S. METR is plotted at 19.7 per cent for 2024 and expected to climb to 24.9 per cent by 2028.
REIT unit-holders hit at front end of distributions
There is also something of a tie-in to issues raised in the 2022 fall economic statement and 2023 federal budget, which ushered in a new tax on the repurchase of equity (also known as share buybacks). Entities that trade on public exchanges will be subject to a 2 per cent tax on the net annual value of repurchased equity, mimicking a 1 per cent levy introduced in the United States last year. In both countries, it’s in part seen as a measure to discourage the redistribution of company profits through share buybacks, which are taxed as capital gains, versus dividends, which are taxed as income.
“Differences in taxation rates between income earned from wages, capital gains and dividends currently favour the wealthiest among us,” the 2024 budget document states. “The proposal would reduce the tax rate differentials that currently exist between the various sources of income, for instance between dividends and capital gains.”
However, real estate investment trusts (REITs) are already compelled through their legal structure to pay out 85 to 100 per cent of their taxable income to unit-holders via monthly distributions. Rather than closing the tax gap between earnings from REIT distributions and stock-related earnings from a combination of dividends and share buybacks, analysts argue that the 66 per cent inclusion rate will hit REIT unit-holders at the front end of their distributions.
“Since REITs do not pay taxes at the REIT level, capital gains from a sale of property are reflected to unit-holders. If capital gains are taxed more now, the tax burden of REIT distributions will be higher,” advises Erkan Yonder, an associate professor of real estate and finance at Concordia University’s John Molson School of Business. “The impact of capital gains tax on regular corporations will be indirect to shareholders, and it will be minimal if the income of a corporation is not dependent on capital gains. So, opposed to the investors of firms with income less dependent on capital gains, REIT investors will be impacted more.”
The 50 per cent inclusion rate for capital gains has been in place since October 2000. That was a year when the government and Finance Minister of the day, Paul Martin, pulled it down, in two phases, from a 75 per cent threshold as the 21st century began.
