Should we tax foreign real estate buyers?

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Should we tax foreign real estate buyers? Benjamin Tal’s writing on this issue comes to a number of unsubstantiated conclusions. One of them is that the main motivation foreign investors in Canadian real estate is not the flipping of the property, but merely to look for a safe haven for their money. Unfortunately, this has little to do with the issue.

Their motivation is one part of the equation. Vacant real estate in markets that are short of supply exacerbates the problem for locals. The prices are driven up by buyers who seem to have virtually unlimited resources. In addition, what should government policy be? To support Canadians in buying homes or foreigners?

In my opinion, writers and “talking heads” such as Mr. Tal have the wrong end of the hockey stick. Canada is a country first and foremost for Canadians. If governments do not protect Canadians what purpose does government serve?

A recent class action lawsuit in BC is a prime example of this. They are taking the position that the rights of foreigners need to be protected. What about the rights of Canadians? Middle-class Canadians are being crowded out of their own housing markets by double standards on mortgage underwriting and competing with foreigners who have more financial resources available to them than the majority of middle-class Canadians. I would love to hear the “talking heads” speak up for Canadians rather than always looking at the so called damage being done to foreigners.

Class action lawsuit in BC

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Class-action lawsuit filed against B.C.’s foreign buyer property tax

Here we go. It was only a matter of time that this type of action would be launched. Interestingly enough, the closing comments on the article are probably the most interesting:

In order to proceed, the claim will have to be certified as a class action by the B.C. Supreme Court, a process that could take months if not years.

In the meantime, it’s expected the province will continue to collect the extra 15 per cent tax.

The arguments against the tax vary from unconstitutional to discrimination. The lawyer involved,  Luciana Brasil, is having her first go at a provincial government. Have a look at her professional bio. Here speciality is class action lawsuits.

It will be interesting to see how this progress, but it would appear to be a long and dusty trail.

Once again it seems that the banks have accommodated this borrower’s based on a deposit rather than income verification. It’s not clear to me how a student can fund the monthly payments on an approximately $500,000 mortgage. But as discussed elsewhere, income verification was likely not one of the tools used to qualify her for a mortgage.

The lead plaintiff in the case is Jing Li, 29, a university student from the People’s Republic of China, now living in Burnaby.

 

Canadian banks’ mortgage guidelines favour foreign home buyers

torontohighwaylandscapeA recent report in the Globe & Mail highlights the lending practices with respect to foreign buyers of Canadian real estate. Reading this article is very disturbing. It claims that there is an unwritten bias towards high net worth foreigners who can qualify for mortgages that Canadians would not qualify for. The underwriting guidelines are structured around the ability of these buyers to provide significant cash down payments in order to qualify for a mortgage.

I find that the allegations made in the article are not terribly surprising. I would express the view that there is little in the way of a solid regulatory framework in place to monitor the activities of the Canadian banks with respect to mortgage lending to foreigners. I am not entirely sure why. But no doubt these jumbo mortgages for large amounts are attractive assets for the banks. Otherwise, why would they bother?

The exemptions appear to be designed to attract citizens of foreign countries and newcomers to Canada as clients by making it less onerous for them to obtain and build credit here. Canadian applicants must still prove their sources of income. Critics say that puts locals at an unfair disadvantage and inadvertently encourages real estate speculation by foreigners who have easier access to credit.

Scotiabank said in a statement that it employs heightened due diligence “in other areas” to compensate, such as full appraisals for all properties. It confirmed that this is an exception from its standard policy for income verification.

The Scotiabank fallback on full appraisals is simply an example of “papering the file”. Appraisals are simply an estimate of the fair market value of the asset being financed. It has nothing to do with the borrower’s ability to fund the mortgage payments. That would require a full review of the borrower’s sources of income, which is a step that the bank actually skips.

The narrative

This plays into the narrative of the Canadian banks on mortgage lending. You’ll see many comments on how the banks are fully secured on their loans. These statistics are frequently rolled out to support the contention that the Canadian banks are prudent in their lending policies in that they can withstand a dramatic drop in real estate prices without fear of loss. The problem is that when real estate prices drop, they will drop materially. It is not a given that the banks will be able to unload these assets in an orderly market at that time at predictable prices.

This is a serious valuation problem when you look at the balance sheets of the Canadian banks. If and when real estate markets drop, there is no certainty as to what the values will be at that time. The 35% cushion may or may not be adequate in a scenario where the market takes a dive.

The Canadian banks are not in the business of managing and liquidating real estate assets. They should be in the business of lending on a prudent basis to fulfill their fiduciary responsibility to depositors. Cash flow is king and asset values should represent a secondary level of protection, not a primary level. In the event that the mortgage holder cannot fund the payments, there is no way of knowing whether the lender will be left whole even at the level of 65% loan to value.

It’s very lenient,” a loans officer from one of the major banks told The Globe. “The foreigners can just get a wire transfer to cover the year’s payments [to qualify] or even borrow money from a friend or a relative to put money in the account temporarily.

Speculation

Needless to say, these kinds of lending practices will fuel the fires of speculation. If you have little real equity in the deal, you are not seriously at risk. For many, one year’s mortgage payments is a pretty efficient way to play the market when there is an 18% gain  in real estate values year over year. The return on equity is enormous.

The federal regulator overseeing Canada’s banks sent The Globe a statement, stressing that banks must attempt to confirm income sources – for all mortgages.

“Whether the borrower is foreign or domestic, OSFI expects that institutions will take reasonable steps to verify income,” said a statement from the Office of the Superintendent of Financial Institutions.

In a strongly worded letter in July, OSFI told banks that rapid rises in the prices of houses in Vancouver and Toronto call for increased diligence because of the risk of defaults if and when “economic conditions deteriorate.”

The regulator made it clear it knows income verification is lacking for non-Canadian clients and it urged lenders to be more thorough.

“Inadequate income verification can adversely affect the assessment of credit risk, anti-money laundering and counter terrorist-financing (AML/CTF) compliance,” it said. “Borrowers relying on income from sources outside of Canada pose a particular challenge … Income that cannot be verified by reliable well-documented sources should be treated cautiously.”

As to why this policy is not vigorously enforced remains an open question. If this is the policy, why do these lending practices continue?

There are many unanswered questions here. But this is starting to bear a remarkable resemblance to what went on in the United States prior to 2008. Hopefully, I am wrong about this. Time will tell. But it seems that more and more information is coming out that would lead a reasonable person to conclude that all is not well.

Welcome to the brave new world

After much posturing, the Bank of Canada has finally acknowledged that we are coming into an era of slower growth. If there is anything surprising about this it’s the fact that it has taken the BofC so long to acknowledge what everyone on the street already knows, that Candian economic growth is no longer a given. Bank of Canada deputy warns investors to adapt because slow growth is ‘new reality’.

It would seem that in this “new era” the pressure on housing as the sole store of wealth will potentially put additional pressure on housing prices.

A while ago I read a report that tried to explain the rise in housing prices in major centers in China. The author concluded that one of the factors was the absence of alternative investments-bonds, stocks, and other financial assets. In the good old days, we bought bonds as the foundation for an investment program. Bonds yields were four or five per cent and you could lock in that rate of return as the basis for your retirement planning. In the era of low-interest rates, this has become impossible.

You don’t need to do a lot of statistical analysis to conclude that the stock market is probably one of the only places that a long term investor has any opportunity to make consistent returns on financial assets. Hard assets such as gold, silver, art and others come and go. Investors who looked to those assets as the foundation of investment portfolios found out that it was a losing strategy.

So what are we left with? Residential real estate for most Canadians who are not financially literate. Canadians being as risk averse as they are seldom are interested in investing in small businesses (the lack of venture capitalists in Canada proves out that point). Those who do start small businesses have little access to capital and bank financing and must self-finance. For those that are successful, my hat’s off to them for sticking it out.

So we get back to investing in residential real estate. Remember, your house was never intended to be an investment. It was supposed to be somewhere to live. In Toronto and Vancouver, it has become a get rich quick scheme. This can only come to one result, crash, crash, crash.

Here come the politicians

Now the politicians have finally gotten wind of it, so eventually they will kill the goose that laid the golden egg for many.

The whole issue of taxes and residential real estate speculation has come to the fore. The government of BC is now encouraging the federal government to more aggressively root out the speculators (Canada Revenue Agency probes tax loopholes in real estate speculation).

Like all Canadians, I am very concerned over allegations that some wealthy Canadians are not paying their fair share of taxes,” Diane Lebouthillier, minister of national revenue, said in a statement. “That is unacceptable and I’ve since asked Canada Revenue Agency officials to look into the specifics of the case.

As I mentioned earlier, residential homeowners are only allowed tax-free gains on their principal residence. I think that it will turn out that many have abused this rule and not declared their income on house purchases and sales where the property is not their principal residence. But go find them notwithstanding the comments of the Minister of National Revenue. It’s one thing to point out the problem, another to offer a viable solution.

Who knows

I have no idea where this goes. I’m not that smart. But one thing I do know is that what’s going on one way or another is unsustainable. When interests rates go up, many homeowners will feel the crunch. If interest rates go up a lot, well look out below.

Crackdown on real estate cheats

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B.C. urges federal government crackdown on real estate tax cheats

Here is an article in the Globe & Mail discussing the Province of British Columbia’s  (B.C.) request to the federal government that it crack down on speculation in residential housing. I have referred to this in an earlier post where those who speculate are, for tax purposes, carrying on an adventure in the nature of trade and hence subject to income treatment on their gains on house purchases and sales rather than availing themselves of the principal residence exemption.

Although an admirable position, I believe that it is very difficult for the Canada Revenue Agency to find them. Unless there is a pattern in the individual’s tax returns of buying and selling houses, a one-off transaction would be difficult to catch. You would need to physically look at the residence to determine use. Not an easy audit task for any government agency.

It’s the same old problem. We do have the rules in place. But their enforcement becomes problematic in that doing so requires human resources that are often not available. So in a sense, it becomes a “toothless tiger”.

In an earlier post, I mentioned that another way to attack this at least with respect to vacant houses is through the property tax system. Enforcement would be much easier at the local level where there are “boots on the ground”. This, in turn, would be backed up by disallowing the principal residence exemption in those cases that surface. This “double punch” would be more than sufficient to cool the flames of those who are looking to speculate in housing. But the devil is in the details.

Interestingly enough, when it comes to certain aspects of enforcing the law, the Province of B.C. takes the following view:

Mr. Kurland also suggested the provincial government should share data with Ottawa, already collected on every property sale, on whether the seller is a resident of Canada for tax purposes. He said he’s been pushing B.C. to do that for two years, because the CRA could then compare property sales data with individual tax records.

He said the Clark government told him that would go against its belief that governments shouldn’t intrude too much into a citizen’s private business.

This is commonly referred to as sucking and blowing at the same time. Privacy trumps illegality apparently in B.C. Perhaps B.C. will institute similar rules to those in place in parts of Europe – the police cannot come into homes at certain hours because it disturbs other local residents. Come on B.C., the rule of law or privacy? Which one is it?