Technical Backgrounder: Housing Insurance Rules and Income Tax Proposals (Revised October 14, 2016)

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.

Mortgage  Insurance

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. 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*

* Revised October 14, 2016

Today, the Government announced a change to the eligibility rules for new government-backed insured mortgages. Effective October 17, 2016, all high-ratio 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 will also be extended to low-ratio insured mortgages effective November 30, 2016 (see below). 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 rates 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 high-ratio mortgage insurance applications received on October 17, 2016 or later. This measure will not apply to high-ratio mortgage loans where, before October 17, 2016: a mortgage insurance application was received; or, 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. 

Homeowners with an existing high-ratio insured mortgage, including those renewing or transferring an existing high-ratio insured mortgage to another lender, are not affected by this change as high-ratio mortgage insurance spans the life of the mortgage.

Changes to Low-Ratio Mortgage Insurance  Eligibility Requirements*

*Revised October 14, 2016

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:

1. A loan whose purpose includes the  purchase of a property or subsequent renewal of such a loan;
2. A maximum amortization length of  25 years;
3. A  property value  below $1,000,000;
4. 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 established amortization schedule;
5. A minimum credit score of 600;
6. A maximum Gross Debt Service  ratio of 39 per cent and a maximum Total Debt Service ratio of 44 per cent, calculated by applying the greater of the  mortgage contract rate or the Bank of Canada conventional five-year fixed  posted rate; and,
7. If the property is a single unit, it will be  owner-occupied.

These changes will not apply to low-ratio mortgage loans where, before October 17, 2016: a mortgage insurance application was received; or, the lender made the loan or 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. The new low-ratio mortgage insurance eligibility requirements also do not apply if, during the period beginning on October 17, 2016 and ending on November 29, 2016, at least one of these three criteria is met and the loan is funded before May 1, 2017.

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:

1. 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.
2. 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:

1. 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.
2. 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.