How Property Taxes Discourage Real Estate Investment and Business (Part 1)

Financial Benefits of Real Estate

The financial benefits of real estate are of two general types:

1. Rental income; and

2. Gain in capital value of the property.

The government taxes either or both of these benefits arising from real estate / real property. A tax on capital value is different from a tax on rental value. Each of these two taxes affects investment in real estate and the real estate business differently.

Effect of Tax on Capital Value

The government levies taxes on the capital value of real estate in at least two ways:

1. Tax on capital value; and

2. Tax on change in capital value.

Tax on Capital Value Increases Holding Expenses

When the government taxes the capital value of real estate, the tax is payable by the owner of the real estate. It increases the owner's holding cost for the real estate: he has to bear a greater cost to retain ownership in his name. If this higher cost becomes unbearable, the owner can get rid of it by selling the real estate. However, prospective buyers, being aware of the holding cost, may be reluctant to buy the property. Hence, there will fewer transactions in the real estate market – a lowered volume of business.

Tax on Change in Capital Value Discourages Property Transfers

When the government taxes the change in capital value of real property, the tax directly impacts real estate market transactions. This is because a major type of real estate market transaction is when properties change hands, i.e., there is change in title of a property, or a property is bought and sold. On transfer of title, the government charges tax on the difference between the buying and selling price. Practical examples of these taxes are:

1 - Capital gains tax; and
2 - Income tax on capital gains.

For a brief introduction to capital gains tax, visit Capital Gains Tax, and for a short explanation of income tax on capital gains, please see Capital Gains. The government collects these taxes on the change in the capital value of an immovable property when the transaction of sale occurs – the time that the capital gain is realized.

Therefore, a person holding a property will prefer not to sell the property to avoid higher tax if he has other options. Similarly, a person who wants to buy a property will consider whether

1. He is buying the property for resale; or
2. He is buying the property for some other purpose.

If the buyer intends to resell the property, he will not get the title to it transferred to his name. The situation is shown in the following diagram:

In the situation shown, A is a seller of real estate, B is a buyer buying the real estate for resale, and C is a buyer buying the real estate for purposes other than sale.

To avoid transfer taxes, B will:

1. Negotiate an agreement to sell with A. That is, he will obtain A's consent that on payment of an agreed price, A will transfer the property to the name of a person other than B;

2. Make a deal with C for purchase of the real estate;

3. Get a sale deed registered between A and C.

Real estate agents use this technique to make deals between two parties without an actual meeting of the parties before execution of the sale deed. There is no transfer of title in B's name, and instead of paying transfer taxes for two transactions, B has avoided the payment for one transaction.

Continued