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.