Owner-occupied property is propped up by a government-sponsored transfer pricing scheme, one that even sophisticated buyers do not realize. Suppose you purchased a profitable Evian water bottling business for $100,000. Then instead of selling the Evian waters to the public, you drink all of it without paying the company. The company’s profits go to zero so its taxes go to zero. You as an individual benefits from all this free Evian water (the return on the $100,000) but you don’t pay taxes on that return because there’s no cash transaction to tax. This is effectively what happens with owner-occupied property. Since you do not pay yourself rent, a significant amount of tax savings is due to owner-occupied property.
In Canada, owner-owned property income is not taxed but mortgage interest cannot be written off. The result, mathematically, is that the before-tax yield becomes your after-tax yield.
In the United States, mortgages are tax deductible despite having no rental income to deduct it against, meaning that although the unlevered yield increases by the inverse of 1 minus the tax rate, the cost of debt remains constant. This often has the effect of drastically improving the after-tax levered yield. A cap rate of 3.0% and interest rate of 3.5% results in a levered after-tax return of 8% assuming 80% leverage and 50% marginal tax rate, which is excellent compared to market alternatives.
The government’s obsession with property ownership has allowed for an unbelievably distorted market. In the example above, even though the unlevered yield is 50bps below the corresponding before-tax interest costs, levering 80% up results in a return that is twice the historical equity market return.
Without a view on price appreciation, buying is optimal when the levered yield is stronger than alternative investment options. This result makes most buying vs. renting decisions quite obvious in the US. The risks to this strategy include changing government regulation and relocation.
|
|
Normal Business |
Canadian Owned |
US Owned |
|
Before tax Unlevered Yield (aka cap rate) |
3.0% |
6.0% |
6.0% |
|
Before tax Cost of Debt |
3.5% |
7.0% |
3.5% |
|
Leverage |
80% |
80% |
80% |
|
Before tax Levered Yield |
1.0% |
2.0% |
16.0% |
|
After-tax Levered Yield |
0.5% |
1.0% |
8.0% |
|
|
|
|
|
|
Tax Rate |
50% |
|
|
|
|
Normal Business |
Canadian Owned |
US Owned |
|
Before tax Unlevered Yield (aka cap rate) |
3.0% |
4.6% |
4.6% |
|
Before tax Cost of Debt |
3.5% |
5.4% |
3.5% |
|
Leverage |
80% |
80% |
80% |
|
Before tax Levered Yield |
1.0% |
1.5% |
9.1% |
|
After-tax Levered Yield |
0.6% |
1.0% |
5.9% |
|
|
|
|
|
|
Tax Rate |
35% |
|
|