Principal Residence vs. Rental Property In Toronto: What’s A Better Use Of Money?
One of the biggest benefits in owning real estate in Canada is that there is no capital gains tax on your principal residence. For properties that aren’t your principal residence, pretax vs post tax gains can be a big difference depending on your personal income tax brackets because capital gains tax can be pretty hefty.
In this video, I’ll compare two options:
- Putting money in a rental property
- Putting money in a principal residence
After the comparison, I’ll reveal what makes more financial sense. Note that this analysis is not financial advice and you should always check with your accountant to verify how it’s done for your particular situation. Now, let’s go over a quick recap of total returns calculations.
Principal Residence Total Returns
On a principal residence, you don’t have rental income, so all housing expenses need to come out of pocket like utilities, property tax, and mortgage payments. The important thing here is that the bigger the property, the bigger your monthly payments tend to be so you need to make sure you can comfortable pay for all of it from month to month and these biggest outgoing expenses will lower your total returns on your primary residence. On the other hand, capital gains here are tax free, which is your biggest benefit in this case.
Here’s a simplified formula for calculating total returns on a primary residence. Because different properties might have different prices, let’s look at things as a percentage of the property price on an annual basis, so that things can be compared apple to apple.
Returns = ( Appreciation - Expenses ) x Leverage
Rental Property Total Returns
On a rental property, rent that you get will pay for a big portion of expenses, if not all of it. The net rent after all expenses are taxed as income based on your personal tax bracket. Practically, accountants might take into account capital cost allowance, essentially depreciation, to defer your rental income to the time of sale but in this video, I’m going to keep things simple and not take that into account.
On top of that, I’m going to make another assumption that you’re at the highest tax bracket at around 50%, so half of your rental income is given away to tax. To make sense of all of this, just know that if you do use CCA or have lower taxes rate, that just means that the rental property scenario might even be more attractive for you.
Now, we’ll move onto capital gains tax on your rental property. Capital gains are big, and if you’re holding real estate for the long haul, that probably means that you’ll be in the highest tax bracket when you sell. Half of capital gains are taxed, so basically your capital gains are subject to roughly around 25% tax. And here’s a simplified formula that I’ll use for calculating rental property returns, and I’ll also look it thing as a percentage of the property’s price on an annual basis:
Returns = [ 75% Appreciation + 50% (Rent - Expenses) ] x Leverage
So now that we have formulas for both options, we can use some more math to get the break even point between the two options.
Appreciation = 2 x (Rent + Expenses)
So let’s see how this applies to Toronto freeholds right now:
- Gross rents are around 5% of the property’s value
- Operating expenses before interest is around 1%
- If you get an interest rate of 2% for your mortgage with 20% downpayment, or 1.6% of your property’s value
So in this case, the breakeven appreciation rate is 15.2%. In other words, if annual appreciation is over 15.2%, putting your money in your principal residence is better. If annual appreciation is less than 15.2% then a rental is better.
Last year has been a big wonky with many homes in the suburbs getting 20%+ in annual appreciation, so putting all your money in a principal residence in the suburbs was a better choice last year. But if we zoom out you have to understand that is 20% per year in annual appreciation NOT normal. On a long term basis, we’re looking around 7-8% annual appreciation in The GTA over the last 20 years. So from a long term investment perspective, putting money into a rental property typically gives you better returns overall.
I did a bit of a sensitivity analysis and here’s a chart that shows how returns vary based on changing appreciation rates. As you can see the breakeven where total returns look better on a principal residence is when the appreciation rate goes over 15.2% which is very atypical. At 7% appreciation, we’re looking at 27% annual total returns on a rental property and 18% total returns on the primary residence so the rental property is a better investment.
Now if you’re making decisions solely based on numbers, then it might make more sense to put it into an investment property. But we’re involving homes at the end of the day, and so that definitely has qualitative aspects, meaning a better quality of life will give primary residence bonus points.
Taking that one step further, this comparison hasn’t taken into account extra costs of living when you put all your money into rental properties. I didn’t factor this in because some people might be able to live at home for free, whereas others might be ok with sharing a home with other tenants, and some others might want a more luxurious home in a great neighbourhood, so definitely factor this into the comparison based on your unique scenario as well.
At the end of the day, most people typically strike a middle ground and put some money into a principal residence so that you can live a comfortable quality of life, and then put the excess in rental properties. If you get anything out of this video, just know that investing in real estate gives great returns regardless as long as you can make the higher monthly payment of home ownership in a principal residence. Even though principal residences have lower returns, 18% annual returns on a principal residence after tax is actually an amazing use of money.
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