Part IV – Real Estate: Creating Cash Flow from the Proceeds from Selling Your House

Prior to selling your home, we encourage you to have a clear plan of what the next stage would look like.

If that next stage is renting, then meeting with your advisor ahead of time is recommended.   Once you sell, the good news is that you no longer have to worry about costs relating to home ownership, including property taxes, home insurance, repairs and maintenance.

Budgeting, when your only main expense is monthly rent, makes the process straight forward.  The key component is ensuring the proceeds from selling your house will be invested in a way that protects the capital and generates income to pay the rent.

The first step is determining the type of account in which to deposit the funds. The first account to fully fund is the Tax Free Savings Account (if not already fully funded). Then open a non-registered investment account for the proceeds.  Couples will typically open up a Joint With Right of Survivorship account.  Widows or singles will typically open up an Individual Account.

The second step is to begin mapping out how the funds will be invested within the two accounts above. A few types of investments that are great for generating income are REIT’s (Real Estate Investment Trust), blue chip common shares, and preferred shares.  Not only do these types of investments offer great income, they also offer tax efficient income, especially when compared to fully taxable interest income.

When you purchase a REIT, you are not only getting the benefit of a high yield, but you are generally getting part of this income as return of capital. The return of capital portion of the income is not considered taxable income for the current tax year.

As a result of receiving a portion of your capital back, your original purchase price is therefore decreased by the same amount. The result is that you are not taxed on this part of the income until you sell the investment at which point if there is a capital gain you will be taxed on only 50% of the gain at your marginal tax rate. You have now effectively lowered and deferred the tax on this income until you decide to sell the investment.

Buying a blue-chip common share or a preferred share gives you income in the form of a dividend. The tax rate on eligible dividends is considerably more favourable than interest income.

Another tax advantage with buying these types of investments is that any gain in value is only taxed when you decide to sell the investment and even then, you are only taxed on one half of the capital gain, referred to as a taxable capital gain. For example, if you decide to sell a stock that you purchased for $10,000 and the value of that stock increased to $20,000, you are only taxed on 50% of the capital gain. A $10,000 capital gain would translate to a $5,000 taxable capital gain.

We have outlined the approximate tax rates with a couple of assumptions.  Walking through the numbers helps clients understand the after-tax impact.

To illustrate, Mr. Jones has $60,000 in taxable income before investment income, and we will assume he makes $10,000 in investment income in 2016.  His marginal tax rate on interest income is 28.2%, on capital gains 14.1%, and only 7.56% on eligible dividends.

If Mr. Jones earned $10,000 in interest income, he would pay $2,820 in tax and net $7,180 in his pocket.  If Mr. Jones earned $10,000 of capital gains, he would pay $1,410 in tax and net $8,590 in his pocket.  If Mr. Jones earned $10,000 of eligible dividends, he would pay $756 in taxes and net $9,244 in his pocket.

The one negative to dividend income for those collecting Old Age Security (OAS) is that the actual income is first grossed up and increases line 242 on your income tax return. Below line 242 the dividend tax credit is applied.  The gross up of the dividend can cause some high income investors close to the OAS repayment threshold to have some, or all, of the OAS clawed back which should be factored into the after tax analysis.  The lower threshold for OAS claw-back is currently at $72,809.  If taxable income is below $72,809 then the claw-back is not applicable.  If income reported on line 242 is above $72,809 then OAS begins getting clawed back.  Once income reaches $118,055 then OAS is completely clawed back.

The schedule for dividend payments from blue chip equities and preferred shares is typically quarterly.  For REIT’s, it tends to be monthly. Once you decide on the amount you want to invest, then it is quite easy to give an estimated projection for after tax cash flow to be generated by the investments.

Preparing a budget of your monthly expenses makes it easy to automate the specific cash flow amount coming from your investment account directly into your chequing account.

Kevin Greenard, CPA CA FMA CFP CIM, is a Portfolio Manager and Director, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria.  His column appears every week in the TC.  Call 250.389.2138. greenardgroup.com 

This is for information purposes only. It is recommended that individuals consult with their financial advisor before acting on any information contained in this article. The opinions stated are those of the author and not necessarily those of Scotia Capital Inc. or The Bank of Nova Scotia. ScotiaMcLeod is a division of Scotia Capital Inc., Member Canadian Investor Protection Fund.

Part I – Real Estate: One of Canada’s Best Tax-Free Investments

Your principal residence is an investment in addition to being a place to live. Success is often associated with that sense of home ownership pride where you have a safe home for your family and where memories are created.

Most Canadians have committed more to their home than any other investment during their lifetime.

Prior to the introduction of the Tax Free Savings Account (TFSA) in 2009, there was really only one mechanism Canadians had to amass significant wealth on a tax free basis – owning your principal residence. The one benefit to real estate over the TFSA is that you’re not limited to the annual contribution limit.  Owning a principal residence and TFSA enables Canadians to maximize tax free wealth accumulation during their lifetime.

It is our belief that tax free is certainly better than tax deferral.   Because of the strong tax characteristics of the TFSA, we consider this a long term “investment” account that should be maximized each year.  Having a properly invested TFSA and owning real estate both protect you against inflation.  If inflation occurs, typically home prices rise from a replacement value perspective.

If TFSAs are invested in appropriate common shares then these also are typically inflation protected.

One aspect of both the TFSA and real estate that we like is that it creates forced savings resulting in greater net worth. Years of forced savings, through mortgage payments, results in debt being eliminated.

I always tell my clients that growing wealthy slowly is okay.  Paying down a mortgage over 20 years is one of those examples.  Although the annual limit for the TFSA may have initially seemed small, it all adds up and eventually begins to snowball over the years if contributions have been maximized.

Both the TFSA and your principal residence provide some flexibility if you want to make a change or need some liquidity. For example, if in a given year you need $20,000 out of your TFSA then you can simply withdraw the funds without tax or penalty.  The added bonus is that the government will let you put that same withdrawal amount back into your TFSA, provided you wait until the next year (assuming you had already maximized your TFSA contributions) or future years.  This replenishment feature does not exist with RRSP accounts.  If individuals take money out of an RRSP it is fully taxed in that year of withdrawal and the room does not get replenished.

Individuals can also sell their principal residence and replace it with another principal residence within reason. Our second column in our real estate series will deal with the new rules which were announced on October 3, 2016.

Estate planning is done for various different reasons, one of which is to reduce taxes during your lifetime. No two assets are better than your principal residence and TFSA when it comes to zero income taxes on the price appreciation.  Individuals can name a beneficiary on the TFSA to avoid probate even upon death.  With respect to one’s principal residence, couples typically avoid probate on the first passing if the home is registered in joint tenancy.  If an individual passes away with a principal residence registered solely in their name, then probate fees will apply.  Probate fees in B.C. are 1.4 percent of that portion of an estate in excess of $50,000 in value.  For a million dollar home this can be approximately $14,000.

In the majority of cases we are able to help our clients through the establishment of an estate plan that also assists them in avoiding this $14,000 probate fee. Our sixth column in our real estate series will go into real estate and estate planning in greater depth.

Kevin Greenard CPA CA FMA CFP CIM is a Portfolio Manager and Director, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week in the TC.  Call 250.389.2138. greenardgroup.com 

This is for information purposes only. It is recommended that individuals consult with their financial advisor before acting on any information contained in this article. The opinions stated are those of the author and not necessarily those of Scotia Capital Inc. or The Bank of Nova Scotia. ScotiaMcLeod is a division of Scotia Capital Inc., Member Canadian Investor Protection Fund.

As tax time looms, it’s prudent to get your plan in place

This time of year you should be talking with your financial advisor about where to put your hard earned money.  Will you contribute to an RRSP or pay down debt?  Or should you do both by contributing to an RRSP and using the tax savings to pare debt?

Contributing to an RRSP should be done with a view of keeping the funds committed for a longer period of time and pulling them out at retirement, hopefully when you’re in a lower income tax bracket. This option is suitable for individuals who have stable income.  If it’s debt reduction, you always have the flexibility of taking out equity in your home later on if capital is needed. On the other hand, if you need capital and your only access to savings are from your RRSP you will have to make one of the most common RRSP mistakes – deregistering RRSPs before retirement and paying tax. In addition, you will not have the RRSP contribution room replenished.

Since 2009, financial options were further complicated with the introduction of the Tax Free Savings Account (TFSA). The main benefit of an RRSP is the deferral of income within the account until the funds are pulled out. Another is the tax savings in the period in which the contribution is first applied. The TFSA has the same first benefit of an RRSP, deferral of all income including interest, dividends and capital gains. TFSA contributions do not provide you a tax deduction; however, withdrawals are not taxed at all. Withdrawals can be replenished in the next calendar year. .

Business owners have the ability to have active small business income taxed at a lower rate. Most owners are encouraged to pull out only the income they need to live on. The rest of the income is left in the corporation. Income paid out of the corporation is either through dividends wages, or both. Should business owners still contribute to an RRSP or TFSA when income is already taxed at low rates?  Wages paid helps future CPP benefits and also creates RRSP deduction room.  Dividends paid can be tax efficient, but do not create RRSP room and have no benefit for CPP purposes.  Some organizations provide RRSP programs that involve matching and length of service programs that are linked to the member’s RRSP.

Singles have a higher likelihood of paying a large tax bill upon death. With couples, the chances that one lives to at least an average life expectancy are far greater. Couples can also income split where the higher income spouse can contribute to a spousal RRSP.

If you have a good company Registered Pension Plan (RPP), you may not have a great a need to have an RRSP. If a person had debt and a good RPP then the decision to pay down debt is a little easier than someone that doesn’t have an RPP at all. Individuals who have no other pensions (not counting CPP and OAS) really need to consider the RRSP and how they will fund retirement.

Income levels below $37,606 in BC are already in the lowest income tax bracket. Contributing $5,000 to an RRSP while in the lowest bracket would result in tax savings of approximately $1,003 or 20.06 per cent.  Income over $150,000 is taxed at 45.8 per cent and this same contribution would save $2,290.   I would encourage the lower income individual to put the funds into a Tax Free Savings Account or pay down debt depending on other factors. If the lower-income individual’s income increased substantially, then the option to pull the funds out of the TFSA and contribute them to an RRSP always exists.

In order for your advisor to provide guidance about the right mix between TFSA, RRSP, or paying down debt, they require current information.  In some cases, your advisor should be speaking with your accountant to make sure everyone is on the same page.  Every situation is unique and your strategy may also change over time.  Preparing a draft income tax return in late January or early February helps your advisor guide you on making the right decisions.

The submitting of your completed tax return should be done only when you are reasonably comfortable you have all income tax slips and information. Some investment slips, such as T3s, may not be mailed until the end of March. We recommend most of our clients do not file their income tax return until the end of the first week of April.  By providing projected tax information to your advisor in January or early February you have time to determine if an RRSP should be part of the savings strategy. If it is not, the discussion can lead to whether you should pay down your mortgage or contribute to your Tax Free Savings Account.  

Most mortgages allow you the ability to pay down a set lump sum amount (such as 10 or 20 per cent) on an annual basis without penalty.  Every January you are given additional Tax Free Savings Account room. 

Fee-based accounts benefit investors in the long run

A fee-based account is a tranparent way of paying your financial advisor.  The fee is charged based on the market value of the assets being managed, and it is distinctly different than a transactional account, where commissions are charged for every buy-and-sell transaction. 

When clients open up a fee-based account, they sign a fee-based agreement that establishes the agreed upon fee, how the fees are calculated, when the fees will be charged and the accounts involved.   

There are a number of benefits for clients in moving to a fee-based account. 

Working on a “fee for service” basis, rather than a commission or transactional fee basis, means the best interests of the client are more aligned with those of the advisor. If fees are based on the market value of the account, then the only way an advisor will be compensated further is if they can grow your account in value.  If your account declines in value, then so does the compensation paid to your advisor.  

Another benefit of a fee-based account is the additional services clients receive from their financial advisor.  Financial professionals today are rarely called stock brokers because the services offered extend well beyond buying and selling stocks. Financial planning meetings cover many topics such as tax and insurance as well as education, retirement and estate planning. 

Financial professionals today spend a significant amount of time understanding each client’s needs and integrating this into an increasingly complex tax and regulatory environment. 

As a result, the amount billed for fee-based accounts is referred to as an “investment council fee” for income tax purposes.  The main benefit is the fees relating to non-registered accounts can be deducted on your income tax return as a carrying charge.  If your fee is one per cent before tax, and your marginal income tax bracket is 30 per cent, your fees have a net cost to you of only 0.70 per cent.   

Fees are typically charged quarterly. As an example, Jane Wilson opened a new fee-based account and invested $750,000 on Jan. 1 with an annual fee of one per cent.  She will have no fees charged for three months. Around the middle of April, the first quarterly fees would be charged at $1,875 ($750,000 x 0.25 per cent).  Wilson’s fees are one-quarter of one percent after each quarterly period. 

Other methods of compensating that are not fee-based often have commission charges upward as high as five percent on the first day of buying the investments. For an advisor to be successful with a fee-based business, he or she needs to establish good long term relationships. 

The periodic payment of fees better aligns the interests of clients and financial professionals.  When explained to clients, most would prefer to spread out the fees over time as services are provided versus paying a large amount on the first day.  

One question we are asked is how the quarterly fees are actually paid.  To illustrate we will use Don Spalding, who has three investment accounts totaling $750,000 – $500,000 in a non-registered account, $200,000 in his RRSP account, and the remaining $50,000 is in a Tax Free Savings Account. 

There are a few different options for how Spalding can cover the quarterly fees. 

The first option is to have the fees charged to each of the respective accounts.  Wilson had only one account and the fee of $1,875 was simply charged to that one account.  Mr. Spalding has three accounts and each account is charged the respective amount based on one-quarter of one percent of the market value of each account. 

The first quarterly amount for Spalding is $1,250 for the non-registered account, $500 for the RRSP, and $125 for the TFSA.  He has the option of keeping cash in each account to cover the fees, depositing cash quarterly or selling investments. 

With fee-based accounts, Spalding has the option to instruct us to designate the billing of the fees to come out of one account.  Don could instruct us to pay the fees for his RRSP and TFSA accounts from the non-registered account.  This enables him to maximize the amount he maintains in his registered accounts keeping it tax sheltered. 

The payment of fees from a designated account enables an advisor to fully invest the non-designated accounts and to utilize compounding growth strategies such as the dividend reinvestment plan.  Fee-based accounts can assist with income splitting as the higher income spouse can pay the account fees of the lower income spouse.

Liquidity is another benefit of fee-based accounts.  As there is no cost to buy investments, the same applies to changing or selling investments.  If you require money for any reason, there is no commissions payable for selling or rebalancing your investments.  Rebalancing can include reducing a position that has performed well, dollar cost averaging on a position that has underperformed, adjusting sector exposure, modifying asset mix, and changing the geography of your investments. 

Another benefit of fee-based is the ability to link additional family members to the platform.  Clients with children and grandchildren often would like introduce them to the benefits of full service brokerage, but do not individually have the capital to be able to open accounts on their own.  This could include parents wishing to assist adult children in opening and funding Tax Free Savings Accounts and grandparents who wish to open Registered Education Savings Plans for their grandchildren.  Fee-based accounts that are linked can make wealth transfer strategies within the family group of accounts significantly easier.

Rebalancing investments in two steps

A disciplined investment process begins with determining the asset mix that is right for you. By asset mix we refer to the portion you have in one of three broad categories of investments, including cash, fixed income and equities. Fixed income includes guaranteed investment certificates, term deposits, bonds, bond exchange traded funds, debentures, preferred shares, etc.. Equities are what many would refer to as the “stock market”. Life, markets and your asset mix all change with time. Decisions you made yesterday may not hold true with new information tomorrow. This is the reason that your investment strategy is not just about the markets. When you buy a house, have a child or approach retirement, your investment goals will change. As your goals change, so might your asset mix. For example, the asset mix of a very aggressive investor would not be suitable for someone who is retiring in the coming years. Just as major life events change us, we can also look at major market events as changing the way we look at our portfolio. For some investors this may be an opportunity for reflection. You may ask yourself if your “normal” asset allocation is still valid once you have considered any changes in your life. If that answer is yes, then when markets change as they do, it may also be time to consider rebalancing your portfolio back to its original mix.

Interest rate changes and market movement results in fluctuations between asset mix. From the day you begin investing, your asset mix is constantly changing. To illustrate, we will use Thomas and Heather Bennett who invested in a portfolio with the following asset mix: Cash 0 per cent, Fixed Income 40 per cent, and Equities 60 per cent. Asset classes do not change at the same rate. Over time, stocks may grow faster than bonds making the growth in your portfolio uneven. For example, the Bennett’s portfolio that started with 40 per cent bonds and 60 per cent equities could drift to 30 per cent bonds and 70 per cent equities if the stock markets rise, or alternatively the other way to 50 per cent bonds and 50 per cent equities if a stock market correction occurs. Regardless of the direction of the change in your portfolio, it is necessary to remember the importance of the reasoning behind your original asset allocation. Although it may seem counter intuitive to sell an asset class that is doing well or buy one that is not, however that is precisely what is required if the fundamental principle of “buy low – sell high” is to be followed. By rebalancing your portfolio, you are staying the course and increasing the potential to improve returns without increasing risk.

Disciplined rebalancing can provide comfort by taking the emotion out of your investment decisions. It does not seem natural to sell a portion of your investments that have done well and buy more of those that have been more sluggish. This discipline allows a reassuring way to buy when it is difficult and sell when it seems counterintuitive. When markets are down, human nature would have us get out rather than buy low, but a disciplined rebalancing process can prevail in the long run.

Although at times, the changes in the market may not be large enough for an investor to feel that there is any need to rebalance, the benefit to doing so can be significant over the long run with compounding returns. It is important to talk to your advisor initially to determine your optimal asset mix that you are comfortable with, often documented in an Investment Policy Statement (IPS). Once you have a documented IPS then your advisor can establish a customized portfolio that matches your IPS.

Rebalancing to your optimal asset mix should be done at least once a year. Prior to rebalancing, it is important to periodically review you IPS to ensure that you’re comfortable with the asset mix. Changes in market conditions and interest rate outlook are factors to discuss with your investment advisor when revising the asset mix within your IPS. Your personal goals, need for cash, and knowledge level may also result in your asset mix needing to be adjusted.

The asset mix is the macro decision within the IPS and is the first step in rebalancing. Step two of rebalancing is looking at the micro items, such as sector exposure and individual companies you have invested in. It also may involve looking at geographic exposure, credit quality and duration of fixed income, and mix between small, medium, and large capitalized companies. Up above, we noted that the Bennett’s initially wanted 60 per cent in equities and started with total investments of one million. The equity portion of $600,000 was divided into 30 companies with approximately $20,000 invested in each company. Over the last year, the Bennett’s now have a portfolio valued at $1,080,000 with 63 per cent in equities and 37 per cent in fixed income. Step one for the Bennett’s rebalancing of the asset mix would result in them selling three percent of equities, or $32,400, and allocating this to fixed income.

Step two in the rebalancing process highlighted that several stocks performed very well and are above the new individual recommended position size of $21,600 ($1,080,000 x 60 per cent divided by 30 companies). We also noted that stocks in two sectors performed very well and have resulted in the portfolio being too concentrated in those sectors. Step two of the rebalancing process resulted in the Bennett’s selling a portion of the star performers in the overweight sector.

When significant deposits and withdrawals are made then this is an ideal time to look at both macro (step one) and micro (step two) rebalancing. This could be when you are making an RRSP or TFSA contribution or when you have to decide what to sell to raise cash for your goals. If no deposits or withdrawals are made then periodic meetings with your investment advisor should have ‘rebalancing your portfolio’ as an agenda item. Some people may want to rebalance quarterly while others may feel an annual check up is sufficient.