Friday, March 9, 2018 / by Ruth Ballantyne
Technical Backgrounder: Housing Insurance Rules and Income Tax Proposals
The Government of Canada recognizes the importance of a healthy, competitive and stable housing market for all Canadians, including the many Canadian families who count their principal residence as both their home and single biggest asset.
The actions described below are meant to respond to the effects of years of low interest rates and changes in the way the market operates. They build on one of the Government’s first steps since being elected nearly a year ago when it raised the minimum down payment for homes priced above $500,000.
In-depth analysis, along with an exchange of views and priorities with provinces and municipalities, has informed this series of complementary measures. They are aimed at protecting the financial security of Canadians, supporting the long-term stability of the housing market and improving the integrity and fairness of the tax system, including ensuring that the principal residence exemption is available only in appropriate cases.
The Government is also evaluating the long-term structure of the housing finance system and is considering whether the distribution of risk is currently balanced and appropriately reflects all parties’ abilities to share in and manage housing risks.
Federal statutes require federally regulated lenders to obtain mortgage default insurance (“mortgage insurance”) for homebuyers who make a down payment of less than 20 per cent of the property purchase price, known as “high loan-to-value” or “high-ratio” insurance.1 The homebuyer pays the premium for this insurance, which protects the lender against mortgage loan losses if the homebuyer defaults.
By reducing risk to lenders, mortgage insurance enables consumers to purchase homes with a down payment as low as 5 per cent of the property value and at lower mortgage interest rates that are comparable to those received by homebuyers with higher down payments.
Lenders also have the option to purchase mortgage insurance for homebuyers who make a down payment of at least 20 per cent of the property purchase price, known as “low-ratio” insurance because the loan amounts are generally low in relation to the value of the home. There are two types of low-ratio mortgage insurance: transactional insurance on individual mortgages at the point of origination, typically paid for by the borrower, and portfolio (bulk pooled) insurance that is acquired after origination and typically paid for by the lender. The majority of low-ratio mortgage insurance is portfolio insurance.
Lender access to low-ratio insurance supports access to mortgage credit for some borrowers, but primarily supports lender access to mortgage funding through government-sponsored securitization programs.
All mortgage insurance in Canada currently covers 100 per cent of eligible lender claims for insured mortgages that default. Mortgage insurance is provided by Canada Mortgage and Housing Corporation (CMHC), a federal Crown corporation, and two private insurers, Genworth Financial Mortgage Insurance Company Canada and Canada Guaranty Mortgage Insurance Company.
The Government backs 100 per cent of the mortgage insurance obligations of CMHC, in the event that it is unable to make insurance payouts to lenders. In order for private mortgage insurers to compete with CMHC, the Government backs private mortgage insurers’ obligations to lenders (in the event that a private insurer is unable to make insurance payouts to lenders), subject to a deductible charged to the lender equal to 10 per cent of the original principal amount of the loan.
The Government guarantee of mortgage insurance is intended to support access to homeownership for creditworthy buyers and promote stability in the housing market, financial system and economy. As part of its role to promote stability, and to protect taxpayers from potential mortgage loan losses, the Government sets the eligibility rules for new government-backed insured mortgages.
Between 2008 and 2015, five rounds of changes were made to the eligibility rules, aimed at encouraging insured borrowers to build and retain housing equity and take on mortgage debt that they are able to service over the economic cycle.
Applying a Mortgage Rate Stress Test to All Insured Mortgages
Today, the Government announced a change to the eligibility rules for new government-backed insured mortgages. Effective October 17, 2016, all insured homebuyers must qualify for mortgage insurance at an interest rate the greater of their contract mortgage rate or the Bank of Canada’s conventional five-year fixed posted rate. This requirement is already in place for high-ratio insured mortgages with variable interest rates or fixed interest rates with terms less than five years.
The Bank of Canada’s conventional five-year fixed posted mortgage rate is the mode (i.e., the most common occurring number) of the conventional five-year fixed mortgage rate advertised by Canada’s six largest banks. The rate is updated weekly and is available on the Bank of Canada’s website (CANSIM table 176-0043). The Bank of Canada’s posted rate is typically higher than the contract mortgage rate most buyers actually pay. As of September 28, 2016, the Bank of Canada posted rate was 4.64 per cent.
For borrowers to qualify for mortgage insurance, their debt-servicing ratios must be no higher than the maximum allowable levels when calculated using the greater of the contract rate and the Bank of Canada posted rate. Lenders and mortgage insurers assess two key debt-servicing ratios to determine if a homebuyer qualifies for an insured mortgage:
Gross Debt Service (GDS) ratio—the carrying costs of the home, including the mortgage payment and taxes and heating costs, relative to the homebuyer’s income;
Total Debt Service (TDS) ratio—the carrying costs of the home and all other debt payments relative to the homebuyer’s income.
To qualify for mortgage insurance, a homebuyer must have a GDS ratio no greater than 39 per cent and a TDS ratio no greater than 44 per cent. Qualifying for a mortgage by applying the typically higher Bank of Canada posted rate when calculating a borrower’s GDS and TDS ratios serves as a “stress test” for homebuyers, providing new homebuyers a buffer to be able to continue servicing their debts even in a higher interest rate environment, or if faced with a reduction in household income.
The announced measure will apply to new mortgage insurance applications received on October 17, 2016 or later. This measure will not apply to mortgage loans where, before October 3, 2016: a mortgage insurance application was received; the lender made a legally binding commitment to make the loan; or the borrower entered into a legally binding agreement of purchase and sale for the property against which the loan is secured. Mortgage loans for which mortgage insurance applications are received after October 2, 2016 and before October 17, 2016 are also not affected by the rule change, provided that the mortgage is funded by March 1, 2017. Homeowners with an existing insured mortgage or those renewing existing insured mortgages are not affected by this measure.
Changes to Low-Ratio Mortgage Insurance Eligibility Requirements
The Government also announced today changes to the eligibility rules for newly insured low-ratio government-backed insured mortgages. These new eligibility criteria will help target the funding support provided by government-backed low-ratio mortgage insurance towards safer forms of lending.
Effective November 30, 2016, mortgage loans that lenders insure using portfolio insurance and other discretionary low loan-to-value ratio mortgage insurance must meet the eligibility criteria that previously only applied to high-ratio insured mortgages. New criteria for low-ratio mortgages to be insured will include the following requirements:
A loan whose purpose includes the purchase of a property or subsequent renewal of such a loan;
A maximum amortization length of 25 years;
A maximum property purchase price below $1,000,000 at the time the loan is approved;
For variable-rate loans that allow fluctuations in the amortization period, loan payments that are recalculated at least once every five years to conform to the original amortization schedule;
A minimum credit score of 600 at the time the loan is approved;
A maximum Gross Debt Service ratio of 39 per cent and a maximum Total Debt Service ratio of 44 per cent at the time the loan is approved, calculated by applying the greater of the mortgage contract rate or the Bank of Canada conventional five-year fixed posted rate; and,
A property that will be owner-occupied.
These changes will apply to low-ratio mortgage loans insured on November 30, 2016 or later. Low-ratio loans for which mortgage insurance applications were submitted prior to October 3, 2016 will not be affected. These new criteria will also not apply to loans for which mortgage insurance applications were submitted between October 3, 2016 and November 30, 2016, provided that the loans are insured by November 30, 2016.
Forthcoming Consultation on Lender Risk Sharing
Today, the Government announced that it would launch a public consultation process this fall to seek information and feedback on how modifying the distribution of risk in the housing finance framework by introducing a modest level of lender risk sharing for government-backed insured mortgages could enhance the current system.
Canada’s system of 100 per cent government-backed mortgage default insurance is unique compared to approaches in other countries. A lender risk sharing policy would aim to rebalance risk in the housing finance system so that lenders retain a meaningful, but manageable, level of exposure to mortgage default risk.
Implementing a lender risk sharing policy would be a significant structural change to Canada’s housing finance system. Today’s announcement will be followed in the coming weeks by a public consultation paper, which will begin a consultation process with stakeholders to determine the suitability and potential design of a lender risk sharing program for Canada’s housing finance system.
Proposed Income Tax Measures
The income tax system provides a significant income tax benefit to homeowners disposing of their principal residence, in the form of an exemption from capital gains taxation (“the principal residence exemption”). However, there are limits to the exemption. The exemption is intended to be available only to Canadian resident individuals and trusts. Also, families are able to designate only one property as the family’s principal residence for any given year.
The proposed tax measures announced today would improve tax fairness and the integrity of the tax system. The first two measures would better ensure that the principal residence exemption is available only in appropriate cases, and in a manner consistent with the Canadian resident and one-property-per-family limits. Specifically, under these measures:
An individual who was not resident in Canada in the year the individual acquired a residence will not—on a disposition of the property after October 2, 2016—be able to claim the exemption for that year. This measure ensures that permanent non-residents are not eligible for the exemption on any part of a gain from the disposition of a residence.
Trusts will be eligible to designate a property as a principal residence for a tax year that begins after 2016 only if additional eligibility criteria are met. These criteria will improve fairness and integrity by better aligning trust eligibility for the principal residence exemption with situations where the property is held directly by an individual. A trust will be required to be—in each year that begins after 2016 for which the designation applies—a spousal or common-law partner trust, an alter ego trust (or a similar trust for the exclusive benefit of the settlor during the settlor’s lifetime), a qualifying disability trust, or a trust for the benefit of a minor child of deceased parents. In addition, the trust’s beneficiary who, or whose family member, occupies the residence for the year will be required to be resident in Canada in the year, and will be required to be a family member of the individual who creates the trust. Transitional relief is provided for affected trusts for property owned at the end of 2016 and disposed of after 2016.
Today’s announcement also includes changes to improve compliance and administration of the tax system with respect to dispositions of real estate. In this respect, the following additional changes are announced for tax years that end after October 2, 2016:
The Canada Revenue Agency (CRA) will require a taxpayer to report the disposition of a property for which the principal residence exemption is claimed. The CRA currently does not require this reporting where a property is eligible for the full principal residence exemption. The change means that, when a taxpayer disposes of a principal residence, the taxpayer will be required to provide basic information in the taxpayer’s income tax return for that year in order to claim the exemption. In addition, the CRA will be explicitly authorized to accept late-filed principal residence designations. More details are available on the CRA’s website.
A proposed measure would provide the CRA with authority to assess taxpayers, beyond the normal assessment limitation period for a tax year, in respect of a disposition of real estate by the taxpayer (or a partnership of which the taxpayer is a member), in cases where the disposition is not reported in the taxpayer’s tax return (or in the case of a partnership, the partnership return) for the year in which the disposition occurs. In the case of property disposed of by a corporation or partnership, the measure would apply only to property that is capital property.
The CRA will continue to work with provincial partners to seek ways to further improve information collected on real estate transactions, and to ensure the effective sharing of this information with tax authorities.
A Notice of Ways and Means Motion with respect to the proposed income tax measures, together with related explanatory notes, are included in today’s release. References in the Notice of Ways and Means Motion and explanatory notes to Announcement Date refer to October 3, 2016.
1 Federally regulated financial institutions cannot provide government-backed insurance on properties at $1 million and higher.