While most Canadians seem to think that housing is the best investment you could make, the main reason to own a home is because you need a place to live.
As a pure investment, housing has a lot of undesirable qualities:
- it’s expensive to buy and sell (realtor and legal fees, taxes);
- its value is tied to the local area (risky);
- it needs to be maintained;
- it’s taxed based on its market value;
- it takes time to buy an sell; and
- you can’t really sell just part of a home.
The most common argument you will hear in favour of housing as an investment is that the value of your property wil go up. And while there are a number of recent examples of housing crashes, housing does generally appreciate over the long term.
The table below from The Rate of Return on Everything, 1870-2015 shows nominal (without subtracting inflation) returns for housing and equity (stocks):
Canada is not in the study, so we’ll take a look at the US. The average return on housing due to capital gains (price increases) was 3.54%, not much above the rate of inflation. The average annual return on equities (stocks)? 11.08%.
From this, it doesn’t look like you should buy a home solely because you expect it will rise in value. But look at the other component of total returns on housing: rental income. This is 5.33% per year and brings the total annual return on housing to 8.87%. Much closer to equities.
But if you don’t rent out your home, does this mean that you only benefit from price appreciation? Not at all. By living in a home that you own, you don’t need to pay rent, which is similar to someone paying rent to you. You can think of it as if you (the tenant) are paying rent to yourself (the landlord), even though no money is exchanging hands. Economists call this imputed rent.
Imputed rent is a real benefit (a few countries even tax it), which is equal to the market rent that your home would generate. And because no money is exchanging hands, this benefit is tax free.
The table below from taxtips.ca shows combined federal and provincial marginal tax rates (tax rate on an additional dollar earned) for Ontario:
The tax-free nature of imputed rent is less important if the tax rates you would face investing in stocks and bonds are close to zero. This could be if you have most of your investments in registered accounts (e.g., TFSAs, RRSPs) or if your taxable income is relatively low.
Investment income from stocks and bonds are a combination of dividends, capital gains and interest. Notice that if you make under $48,000 per year, the marginal tax rate on Canadian dividends is negative, the marginal tax rate on capital gains is only 12.08%, and the marginal rate on other income (e.g., interest, foreign dividends) is 24.15%.
But in higher income brackets, the tax free imputed rent combined with the tax free capital gains that a house generates tax can be quite competitive with after-tax stock market returns.
If you make $100,000 per year, the tax rate is 25.38% on Canadian dividends, 21.7% on capital gains, and 43.41% on other income. If you make over $220,000 per year, it is 39.34% on Canadian dividends, 26.76% on capital gains and 53.53% on other income.
Basically, the lower your income, the more it makes sense to rent and invest in stocks and bonds. The higher your income, the more the tax benefits of imputed rent make home ownership more attractive relative to investing (outside of TFSAs/RRSPs).
So the next time someone asks why you bought your home, tell them that you did it for the imputed rent!