Using RRSPs for real estate, higher learning

Saving for education, paying off student loans or buying a home often have higher priorities for young people than contributing to an RRSP.

But the Home Buyers Plan and the Lifelong Learning Plan can provide options for anyone saving for retirement but in need of investing in more immediate priorities – especially with the increasing price of real estate and tuition.

The Lifelong Learning Plan allows you to withdraw up to $10,000 in a calendar year from your RRSP to finance training or education.  You cannot withdraw more than $20,000 in total.  To qualify, three conditions must apply:

  • The student must be a full-time student or a part-time student if he or she meets the disability conditions.
  • The RRSP owner has to be a resident of Canada.
  • The student has to enroll in a qualifying educational program at a designated educational institution.

People may participate in the plan as many times as they wish after repaying an LLP withdrawal.  Older students should keep in mind that the education has to be completed before the end of the year the person reaches the age of 71.

You and your spouse may be participants in the LLP at the same time.  You may also use the LLP for either or both of you.  You may be eligible to participate in the LLP even if you have withdrawn amounts from your RRSP under the Home Buyers’ Plan  that have not been fully repaid.

Students must receive a written offer to enroll before March of the year after a withdrawal from their RRSP.  Participants who withdraw funds from their RRSP under the LLP must repay the amounts over a period of up to ten years.  For example, Suzy withdrew $8,000 from her RRSP to attend a program at the University of Victoria on March 1, 2006 that finished in 2006.  For 2008, Suzy should repay at least 1/10th (or $800).

This program may be suitable for younger or mature students with an RRSP, individuals who have been laid off, or simply someone interested in a method to fund higher learning costs.

With the Home Buyers Plan, younger people who begin contributing to an RRSP may not even own a house yet.  Does it make sense to contribute to an RRSP if you think you will need to keep funds liquid to buy a home?

In some cases the answer is yes, especially if a person is earning good income.  The HBP allows participants to withdraw up to $20,000 in a calendar year from an RRSP to buy or build a qualifying home.  Couples may each utilize the HBP (combined maximum of $40,000).  The plan may be suitable for any first-time home buyers who are buying a home and may need additional funds to pay for a down payment or reduce financing costs.  A larger down payment may eliminate the costs to insure the mortgage.

The Home Buyers Plan is open only to first-time buyers and applicants should check for specific details on who can apply.  Participants in these plans should understand that withdrawals need to be repaid or have the amount included as taxable income.

The first repayment is due the second year following the year in which a withdrawal is made.  Each year, Canada Revenue Agency will send you a Notice of Assessment  with a statement including: amount repaid (including any additional payments), HBP balance, and the amount of the next repayment to make.

Participants have up to 15 years to repay the amount that is withdrawn under the HBP. Generally, each year the repayment amount is approximately 1/15 of the total amount withdrawn until the full amount is repaid to your RRSPs.   For example, if Bill withdrew $15,000 from his RRSP in September 2007, he must pay at least 1/15th (or $1,000) of the withdrawal in 2009 (or the first 60 days of 2010).

Withdrawals from an RRSP account are generally considered taxable income.  Financial institutions are required to withhold the following tax on RRSP withdrawals:  10 per cent on the first $5,000, 20 per cent between $5,001 and $15,000, and 30 per cent on amounts greater than $15,000.   Two exceptions to this rule are if you give the financial institution a signed form T1036 (HBP) or RC96 (LLP).  These forms allow a financial institution to release the full amount of funds to you without withholding tax.

Both plans require the participants to file a completed Schedule 7 with their income tax return to designate the contributions as either a LLP or HBP repayment.  Failure to complete this schedule may result in CRA including the required repayment as income and assessing your tax return accordingly.  The repayment may be done to an existing RRSP account or to a new one.  The RRSP issuer should give the participant an official receipt for the contribution.

Liquidity is a very important component to consider if you are looking at participating in one these plans.  Cash has to be available within the RRSP account.   Some investments that may be purchased within an RRSP are illiquid or require fees for selling early.

Before you pay your tuition or buy a home you may want to consider all of your funding options.  A simple strategy that applies to both plans is making a contribution to an RRSP to receive the deduction (and possible tax refund).   Care should be taken to understand all important dates and all exceptions that are specific to both plans.

Prior to considering these plans you should read the CRA guides RC4135 (HBP) and RC4112 (LLP) available in both printed versions and online.

 

To trust or not to trust, that’s the question

The popularity of income trusts had been on the rise for years.  With monthly payouts and enhanced yields amid declining interest rates, many investors considered the trust attractive.  The Conservative government’s election promise to leave the taxation of income trusts alone further enhanced the popularity.

But everything changed on October 31 when Ottawa announced its “Fairness Plan,” a move to redesign the way income trusts are taxed that may investors felt was unfair.  Here’s a primer on the issue:

So what is an income trust?

An income trust is an equity investment that was designed to distribute cash flow generated from a business to unit-holders.  People requiring income from their investments were attracted to this structure as income is generally paid monthly or quarterly.  As a result of these distributions income trusts are often referred to as “flow-through” investments.  They typically fall under the following four categories:  1) royalty/energy trusts; 2) income/business trusts; 3) limited-partnerships; and 4) real estate income trusts.

Why were income trusts were created?

Investors who require income found trusts attractive as many paid out income on a monthly basis.  Over the past few years in an environment of declining interest rates, they provided an opportunity for risk tolerant investors to enhance their yield.  The majority of investment returns tend to be generated by the monthly/quarterly distribution stream while total returns may be increased or reduced by changes in the underlying unit price.  With an aging population there is no surprise that there was a strong demand for quality income trusts paying investment income.

What is the problem?

Income trusts are designed to be tax efficient.  Their tax effectiveness comes from the trust being able to distribute the pre-tax business income out to unit-holders.  Provided this income is distributed out to unit-holders then the trust has little to no tax to pay.  People receiving distributions from income trusts may or may not have been taxed immediately on these amounts.  Individuals holding these investments within registered plans, such as RRSP and RRIF accounts, were able to defer tax on this income even further.  The trust structure is considerably different than a corporate structure that must first pay tax on company profits prior to paying dividends to shareholders.  This is the primary problem that led to the recent announcement.  Ottawa may not have been too concerned in the past when trust conversions were primarily done by smaller businesses and taxation dollars were minimal.  With the recent announcements by BCE and Telus to convert to an income trust structure the Government was compelled to act in the interest of supporting their eroding tax base.  It is clear this became a greater issue when some of Canada’s largest companies began contemplating trust conversion.  As a result the Federal Government announced a new Tax Fairness Plan designed to balance the taxation of income trusts and corporations.

Tax Fairness Plan

The proposed Tax Fairness Plan has impacted income trust investors with the exception of those invested in real estate income trusts.  For the other three types of income trusts, profits within the trust will be taxed at corporate tax rates before distributions and distributions will subsequently be treated as dividend income.  These proposed changes are to take effect in the 2011 tax year for trusts that are currently publicly traded.  New income trusts that begin trading after October 31 are impacted immediately.

Political risk in Canada

Prior to investing in income trusts investors should have been aware that this recent announcement from Finance Minister James Flaherty was at least a possibility.  Just over a year ago, former Finance Minister Ralph Goodale spooked income trust investors by announcing that the Liberal Government was looking into the taxation of income trusts.

Ongoing risks

Prior to October 31, many investors may have felt the greatest risk to investing in income trusts is political uncertainty.  Another major risk is that distributions are not guaranteed.  When distribution payments are reduced, people’s income stream will be reduced and the market tends to respond negatively.  One common way to analyse income trusts is to look at the stability of distributions and the payout ratio (cash distributions dividend by available distributable income). Payout ratios greater than 100 per cent of available distributable income is generally an indicator that the trust may need to adjust the distribution level.  Volume of trading is also a concern with some income trusts.  Supply and demand has always driven the markets and some trusts are relatively illiquid.  Energy and resource related trusts are generally impacted either negatively or positively by changes in the price of the underlying commodity.  Changes in the level of interest rates have also had a significant effect on unit prices.  As with any equity investment, it is important to continually analyse the merits of the underlying business.

Coming Up

Many investors may be concluding that the existing trust market is likely to shrink considerably by 2011.  Our next column will provide a few options for investors to consider.  We will also provide an illustration of an investor with a diversified portfolio.

Mortgages: Pay Yourself

Individuals may hold their personal mortgage as an investment within an RRSP in the same way as your RRSP can hold GICs, stocks and mutual funds.  This allows the homeowner to pay themselves interest on their mortgage.

Holding your personal mortgage within an RRSP may be one way to eliminate the frustrating conflict of making regular contributions to your RRSP while making payments on the funds you’ve borrowed to pay for your home.

First things first

Arranging your mortgage within an RRSP is not as straight forward as purchasing investments typically found in such plans.  Administrative procedures are not routine and the associated costs may lead you to meet with your accountant and financial advisor to see if the numbers make sense.

Items to Consider

  • The first step is to determine if you have sufficient assets to make the mortgage option cost-effective.  Homeowners must have a cash balance (or liquid investments) within their RRSP equal to the amount of the desired mortgage.  If fees are incurred to convert your investments into cash these should be considered and factored in.
  • Some institutions may not be able to administer this strategy. Others may have systems in place that allow them to only administer specific mortgages.
  • By following proper procedures and providing the necessary documentation there are no tax consequences involved in setting up a mortgage within your RRSP.  The proceeds from the mortgage within your RRSP can simply be used to pay off your other existing mortgage.
  • The mortgage must be based on posted or market rates and have terms and conditions that reflect normal business practices.  Unlike a normal mortgage where you try to negotiate down from posted rates, you will actually want a higher rate because you are paying yourself.
  • As interest and principal payments flow back into your plan monthly, they are able to compound more rapidly and provide frequent opportunities to reinvest in other RRSP-eligible investments.
  • The fact that you now have a mortgage in your RRSP does not affect your ability to contribute to your RRSP in any way. Your annual contributions will continue to add to the overall value of your RRSP.
  • One of the requirements of having your mortgage in your RRSP is to obtain insurance (CMHC – Canada Mortgage and Housing Corporation).  As your mortgage is secured by your own personal property it is generally considered a high quality investment.
  • There are no restrictions as to how you use the funds borrowed through your mortgage.

Initial Administrative Costs

For those financial institutions that offer this service, they may have different fee structures.  Generally, they are as follows:

  • An initial set up fee of approximately $300 may be charged
  • The mortgage trustees, likely another legal entity, may also charge a set up fee of approximately $100
  • Insurance (CMHC) application fee of $75
  • Mortgage insurance premium can range from 0.5% to 2.75% of the amount of the mortgage depending on the amount of the mortgage and its loan-to-value ratio  (Note: the premium is based on the total amount of the mortgage, regardless of the portion held within your self-directed RRSP)
  • Legal fees estimated at $400
  • Appraisal fees of $275

Monthly and Annual Maintenance Fees

  • The mortgage trustees may charge a monthly administration fee of approximately $16
  • An annual mortgage administration fee may apply of approximately $60, this is in addition to any self directed RRSP fees you may be paying (generally around $125 annually)
  • Other fees, such as transfer-in, discharge and early renewals may also apply in some situations

Two additional components that may influence your decision are current posted mortgage rates and the yields on comparable low risk investments with the same time horizon.

An individual with $80,000 could purchase a low risk investment, such as a GIC or consider the mortgage within their RRSP option.  What is the difference in the return obtained from a mortgage versus a comparable low risk investment?  If this difference exceeds the cost of the strategy then this option may be worth considering.

For mortgage balances below $80,000, individuals may find that the fees offset any benefits enjoyed from setting up the program. After considering the costs involved with this strategy it may only provide benefits for some investors.

Your investment advisor should be able to assist you with an analysis that takes into account your personal circumstances including your risk tolerance, assets within your RRSP, the length of time the program will be in place, your mortgage rate and your current return expectations. This will help determine if holding a mortgage within your RRSP is a good strategy for you.

Strategies of Reverse Mortgage

What are the options for retired people that become house rich and cash poor?  Our last column touched on one simple strategy that we really like – deferring property taxes.  Another strategy that people have asked us about are reverse mortgages.  What are reverse mortgages and when do they make sense?

Reverse mortgages are residential first mortgages secured by a specific property, and offer individuals over the age of 60 a means of converting a portion of the equity in their home into cash.   Let’s compare a regular mortgage with a reverse mortgage.

With a regular mortgage interest and principal payments are made on the original amount borrowed.  With a reverse mortgage individuals may request an amount based on the equity in their homes.  However, no interest or principal payments need to be made until you move out of or sell the home.

Reverse mortgages are offered through the Canadian Home Income Plan Corporation (CHIP).  This Corporation refers to them as CHIP Home Income Plans.  CHIP began operations in British Columbia in 1986, before moving into Ontario in 1996 and the rest of Canada in 1998 and 1999.

From CHIPs website www.chip.ca you can obtain the following information: 

  • You can receive between $20,000 to $500,000 from your home equity. The specific amount is 10% to 40% of the current appraised value of your home, based on your age and that of your spouse, and the location and type of home you have.
  • The current interest terms are:  six months 7.5%, one year 8.25%, three years 8.60%.
  • Annual discounts are available after three years and balance discounts are available if the outstanding balance on your CHIP Home Income Plan exceeds $100,000 or more.
  • Set up costs that the home owner pays are approximately $675 which is an estimate of the independent home appraisal costs and independent legal advice.
  • In addition, closing costs of $1,285 are added to your CHIP Home Income Plan.
  • You have the option to repay in full at any time.  When you repay, an interest differential may apply (limited to three month’s interest).  If you repay within the first three years, a prepayment amount will apply.  These may be waived or reduced in the event of death or a move to a long-term care facility or retirement residence.

Let’s use an example of a 65 year-old living in a $500,000 home that requests proceeds of $80,000 under the CHIP Home Income Plan.  This individual would have initial costs of approximately $675, representing estimated appraisal costs of $275 and independent legal fees of $400.  In addition, closing costs charged by CHIP of $1,285 would be added to the CHIP Home Income Plan resulting in an initial balance of $81,285.

Interest would begin accruing on the initial balance of $81,285 on the one year CHIP plan at a current rate of 8.25 per cent.  The net proceeds are approximately $79,325 ($80,000 received from CHIP less appraisal and legal fees of $675).  Remember, individuals that participate in these plans are not required to make payments.  The compounding component magnifies when no interest or principal payments are made.  The accumulated cost under the CHIP plan after years one, two and three are $88,129, $96,239, and $105,096, respectively.

With the CHIP plan individuals are initially required to withdraw a minimum of $20,000.  The set up costs as a percentage based on this amount is high.  This may encourage individuals to take a greater lump sum when they may need a much smaller monthly amount.  Is the CHIP plan the best option for an individual that only needs an extra $500 a month to make ends meet?

These plans are costly to set up.  The interest rates charged are higher than posted rates on standard mortgages.  As an example, the current three-year CHIP rate is 8.6%, compare that to 6.1% representing the average posted rate of the chartered banks for the same term.  If the fair value of your home is not appreciating then the interest accrued can quickly wash away equity in your home.

The CHIP plan is voluntary and provides a unique opportunity for individuals to stay in their homes that they live in while enjoying retirement.  It may be difficult for some individuals to see this component of their equity diminish.  Possibly the saying, “you can’t take it with you” applies to those who are not interested in maximizing the value of their estate.  A CHIP plan may be a way to have your cake today and eat it too!

Here are some basic strategies to assist individuals in staying in their homes:

  1. While you are still working and eligible to qualify for a line of credit we recommend that you do so prior to retiring.  We also recommend that you apply for the maximum limit that you can qualify for.   Having this in place may provide you the flexibility of drawing only what you need at retirement (i.e. $500 per month).  The interest rate charged will likely be more competitive than a reverse mortgage.
  2. If you’re over 60 years old and cash flow is a concern, you may want to consider the Property Tax Deferment program.
  3. If you are running low on retirement funds you may want to consider paying interest only payments on certain debts such as your line of credit.  Paying interest only payments on debt that has a reasonable interest rate may provide the necessary capital to prolong the stay in your home.
  4. Peace of mind at retirement can certainly be enhanced in the absence of financial concerns.  Sometimes downsizing into a smaller home may provide the necessary capital to fund retirement expenses.
  5. Utilizing a reverse mortgage is always an option.  The Chip Plan does provide individuals the ability to stay in their homes longer, but at a cost.

Individuals that are interested in a reverse mortgage must seek independent legal advice.  On a cautionary note, people who are interested in a reverse mortgage should also consult with their investment advisor or accountant to determine if a reverse mortgage is the best strategy and if it makes sense for them.

The option of putting off your property taxes

The Property Tax Deferment Program in British Columbia was established in 1974 intending to assist seniors and the disabled.  The program ensured that the property tax burden each year would not result in an individual having to sell their home to cover this obligation.

The general Property Tax Deferment qualifications require that you:

  • Must be 60 years of age or older or a surviving spouse or a person with disabilities;
  • Be a Canadian citizen or permanent resident under the Immigration Act;
  • Have lived in British Columbia for at least one year prior to applying;
  • Apply on the home in which you live; and,
  • Have a minimum equity of 25% in your home based on assessed values as determined by BC Assessment Authority

Source:  Ministry of Small Business and Revenue – Property Taxation Branch

You can visit the Ministry of Provincial Revenue’s website at www.rev.gov.bc.ca/rpt or call their toll-free number (1-800-663-7867) for complete details on the program and to obtain information on how to apply.

After reading through the material you may find the following few components to the deferment program interesting.

Interest Charges

If you choose to defer your property taxes the deferred balance will be charged simple interest at a rate not greater than 2% below the rate at which the province borrows money.  The interest rate is set every six months by the Minister of Provincial Revenue.

A key benefit to note is that the deferred amount is charged simple interest, this is better than compound interest that charges interest on interest.  Another benefit is that the interest rate charged is not greater than 2% below the rate at which the province borrows money.  Currently the interest rate is 2.25% and is set for the period October 1, 2005 through March 31, 2006.  The rate may change every 6 months and will be reset again on April 1, 2006.

Means Test

One of the most interesting components to this program is that there is no mention of a means test.  Individuals of all income levels may apply provided they meet the general qualifications.  Although the program may have been designed for those struggling to pay expenses, others may also take advantage of the terms of deferment.  With the interest charges as low as they are, individuals may choose to defer their property taxes for a variety of reasons.  From an investment standpoint this may make sense if an investor feels they could generate an after tax return greater than the interest charges.

A Look at 2005 Numbers for Vancouver Island

Jurisdiction

# of Households

 $ Amount Deferred

 

 
Saanich

682

           1,912,021.64
OakBay

245

              952,723.68
Victoria

285

              705,659.12
GulfIslands rural

252

              696,265.03
Nanaimo

296

              636,023.79
North Saanich

160

              506,056.70
Alberni rural

217

              497,008.03
QualicumBeach

192

              447,882.80
Central Saanich

109

              341,133.20
Duncan rural

134

              269,470.03
Comox North rural

120

              263,405.12
Sidney

112

              223,643.74
Parksville

93

              194,862.74
North Cowichan

103

              185,388.87
Esquimalt

67

              180,216.27
Nanaimo rural

77

              148,941.04
Courtenay

82

              138,704.13
Comox

63

              107,709.10
Campbell River

69

                95,948.95
Lantzville

27

                72,574.49
Colwood

38

                70,139.30
Ladysmith

35

                69,045.86
Port Alberni

49

                60,550.81
Langford

33

                44,582.71
Tofino

6

                36,868.42
Campbell River rural

15

                27,988.49
View Royal

19

                25,776.34
Sooke

16

                21,789.48
Metchosin

10

                18,518.02
Highlands

7

                17,600.48
Duncan

11

                11,827.35

Source:  Ministry of Small Business and Revenue – Property Taxation Branch

The above highlights Vancouver Island jurisdictions that are utilizing the program.   Saanich leads the way with 668 households currently deferring close to two million dollars worth of property taxes.  In retirement areas, such as QualicumBeach, we were surprised to see only 192 households currently deferring their property taxes.  We did not list those jurisdictions where the total deferred amount was less than $10,000.  The table above highlights that many communities are not taking advantage of this program.

Four Strategies to Consider

Strategy 1:  The most basic strategy is to use the funds that you would normally use to pay property taxes to fund day-to-day expenses.  This strategy is essentially the main reason the program was put into place.

Strategy 2:   Another strategy for the use of the funds is to build up your investment savings.  Topping them up now may prevent you from running into financial problems in the future.

Strategy 3:  For individuals that are in their early 60’s and still earning significant income, redirecting the cash to top up your RRSP contribution may be a prudent move.

Strategy 4:  If your ultimate objective is to enhance your overall estate value then proceeds could be used to fund a life insurance policy.

Prior to implementing any of the above strategies, you should contact your accountant and financial advisor to see if any of the strategies may be appropriate for you.

Real estate versus stocks: Homework may surprise

Everyone needs a roof over their head.  The tax benefits that are afforded to personal residences make this an obvious investment opportunity that should not be passed over.  Standard financial planning advice generally suggests that paying down the mortgage on your personal residence and contributing to your RRSPs should be done prior to pursuing other investment opportunities.

What if the mortgage is paid off and the RRSPs have been maximized?  Where should you invest that excess cash?  Beyond your personal residence, does it make sense to start acquiring other real estate properties or should you look at other asset classes?

A common misconception is that real estate is lower risk than investing in the stock market.  Another misconception is that real estate has better long-term returns.  Recently we were speaking with a realtor that understood and pointed out that equity markets have outperformed real estate historically.  Let’s compare real estate investments (excluding your personal residence) with other asset classes.

Irrational Exuberance

We are only a couple of weeks away from the sixth anniversary of the technology sector’s historical highs.  At that time many investors over weighted the sector while ignoring opportunities available in other sectors and other asset classes including real estate.  The technology sector sold off sharply.

Fast forward a few years later and we find investors focusing on resource companies and real estate opportunities. There are several explanations for the focus on real estate with the primary reason being low interest rates. Certain real estate markets have witnessed increased demand resulting in even greater price volatility.  In our opinion, it is this irrational exuberance that has fuelled local real estate prices. Investors have to ask themselves if valuations have gone too high too fast.

Real Estate versus the Stock Market

Many investors have the perception that real estate is a better long-term investment than the stock market.  Part of this perception may be linked to the effort involved in making the investment.  When purchasing a home, investors walk through the house, view similar houses and look at recent sales to see if the asking price is reasonable.  Many people take the time to understand what they are buying.  When a real estate purchase is made the holding period of the investment is generally long term.  These are all great characteristics of solid investing – doing your research and holding quality investments for the long term.

Do individual investors spend the same amount of time to understand the stocks that they are purchasing?  We feel that those that do spend the time to do research, or seek out a qualified advisor, will certainly fair better in the markets than those that do not spend the time.  If one is going to compare the performance of equities against real estate, research before you purchase and compare the returns over the same long term time horizon.  Your homework will reveal that equity returns, for many periods, have exceeded real estate returns.

Using Leverage

Another difference between stocks and real estate investments is that individuals are more willing to borrow money to purchase real estate than stocks.  Individuals for the most part tend to feel more comfortable with leverage on real estate.  Let’s look at the following two examples:

Investor A puts $50,000 down on a $300,000 house five years ago.  Let’s assume that today the house is worth $480,000.  The house value has increased by 60 per cent but the return on your original investment of $50,000 equals $180,000 representing a 360 per cent return on your initial investment.

Investor B puts $50,000 into stock investments within a cash account five years ago.  After the same five-year period the stock investments have climbed to $80,000.  This $30,000 also represents a 60 per cent increase.  As the investor chose not to use margin or debt to purchase the investments the return on original equity also equals the actual return.

The above highlights Investor A using leverage when market values have increased.  Take a moment to consider the results if the opposite happens and market values decline while interest rates rise.  If Investor A becomes too highly leveraged and the cost of borrowing increases this may lead to bankruptcy.

Wealth can be achieved and lost more quickly using leverage and other people’s money.

Very few investments provide the ability to extend leverage as much as real estate.  The equation is easy, greater leverage equals greater risk.  Having all your investments in one asset class such as real estate also adds risk.   The housing market has moved along at full steam for quite some time.  But how long will it last?