Tax Avoidance on New Homes

The Ontario budget announced plans to change the sales tax structure on new homes. The way the harmonized sales tax will be applied starting in mid-2010 will create some perverse incentives that are likely to result in a cycle of tax avoidance and modified regulations.

Under the new plan, all new homes will be taxed at the HST rate of 13%, but those selling for less than $400,000 will get a 6% rebate. New homes selling for more than $500,000 will get no rebate. The rebate gradually fades away between these two prices.

A common reaction to all this “good – let the rich people who can afford big houses pay.” Even if you think this way, consider that if these thresholds remain the same in the future, inflation will eventually push the price of even modest new homes past these thresholds. Inflation will create a hidden tax increase each year.

The sales tax on a $400,000 home will be $28,000, and the sales tax on a $500,000 home will be $65,000. This means that the marginal tax rate will be 7% up to $400,000, but on the next $100,000 it will be 37%! After $500,000 the marginal rate drops to 13%.

The huge tax rate of 37% from $400,000 to $500,000 will create a strong incentive to avoid taxes. We’ve already heard of strategies of builders selling homes before they are finished and leaving it to the home owner to complete the job.

Another possible strategy might be to sell a house on a minimal piece of land and sell the rest of the land in a separate transaction. No doubt the housing industry will find many more creative ways than this to avoid the ultra-high sales tax rate. This isn’t intended as an indictment of the housing industry. Almost all of us try to avoid high taxes.

These tax avoidance efforts will force the government to close loopholes, and the cycle will go back and forth. All this effort will be driven by bad tax policy.

A curious side effect of the tax rules amounts to social policy. House builders are now discouraged from building homes that would sell for more than $400,000. If they must go over this threshold, they might as well go way over and go after the high end of the market. We can expect the $400,000 to $600,000 range to be a little thin.

One potential fix is to give all new home buyers a 6% rebate up to $400,000. This would give a fixed rebate of $24,000 on high end homes, and the marginal tax rate would not exceed 13%.

Another possibility is to reduce the rebate over a wider range of prices, say from $400,000 to $800,000 (instead of only $500,000). In this case, the marginal sales tax rate never goes over 19%.

Punitive marginal tax rates are bad tax policy that create strange incentives and foster tax avoidance. Governments need to make tax rate structures smooth.