Two Properties, One Complex Problem
Created on Friday, 01 April 2011 08:00
In British Columbia, a couple we’ll call Harry, 36, and Felicia, 33, have a 15-month-old daughter and a complex problem. Their total combined monthly take-home income, $7,594, plus $400 of rental income, adds up to $7,994 per month. It covers current expenses, but for the future, income gains will have to come from Harry’s job.
Felicia, recently diagnosed with a neurological condition, is on long-term disability that pays her $2,394 a month after tax. Harry, an architect, works four days a week for monthly take-home income of $5,200. Their combined income services mortgages of $606,000 on their house and $384,000 for a rental property. Those two mortgages with associated property taxes take $5,420 out of their monthly take-home income. Property taxes take another $509. That’s a whopping 74% of after-tax income.
Family Finance asked Derek Moran, a registered financial planner who heads Smarter Financial Planning Ltd. in Kelowna, B.C., to work with Harry and Felicia.
“They have single-digit returns from their rental investment. But they have exposed themselves to higher interest rates and even a declining property market,” the planner says.
Spending almost three-quarters of disposable income on mortgages and property taxes leaves little room for other things, especially the costs of raising their child. Harry and Felicia have just $20,000 in RRSPs or other financial assets, not including $2,400 in a registered education savings plan. Expenses eat up total after-tax income with almost nothing left for little extras.
Felicia’s disability payments of $2,394 a month are net of 10% tax at source. Disability payments are usually not taxed, but in her case, premiums became taxable because of the way the employer structured her pay. Her disability payments are indexed and she continues to earn pension credits.
The Five-Year Plan
Year 1 (2011) The rental property with an estimated value of $585,000 brings in $2,500 a month and costs $2,060 to operate, including $1,860 of payments on their $384,000 mortgage, incidental expenses and property taxes. That leaves a nominal return of $440 a month. On average in the first year, the cash return from rent plus increase in owner’s equity through mortgage payments is $893. That works out to $10,716 a year for a yield of 5.33% on $201,000 of equity. It’s not much considering the debt they are carrying to get that income..
They can sell the property. They lived in it as a principal residence until they bought their current house, so any gain on the house, which was converted to rental use in June 2010, should be almost entirely exempt from capital gains tax, Mr. Moran says. Harry and Felicia acted intelligently by documenting the value of house before it became a rental property. The rental property is not only a dubious investment, it could turn into one that is hazardous to their financial health if interest rates rise by just 1.38%. That would turn their rental yield into a zero return. At present, the return is not sufficient to justify the risk, the planner insists.
Year 2 (2012) Assuming they have sold the rental property, captured the $201,000 of equity (we’ll ignore potential selling costs), and rolled that money into paying down the mortgage on their home, they can cut amortization from the present 20 years and six months to 12 years and two months. That will save them $165,300 in interest, assuming no change in their mortgage rate, Mr. Moran says. Discretionary cash is growing.
Year 3 (2013) Cash realized through selling the rental property should be allocated first to Harry’s RRSP, but not to Felicia’s, for her tax rate does not make RRSP contributions efficient. Harry’s RRSP limit is 18% of gross income, or $15,552. He already contributes $7,000 a year, so there is $8,552, or $713 a month, of space left to fill. Assuming the full $15,552 is added each year to the current $20,000 RRSP balance until he is 60 and assuming the money grows at 6% each year less 3% for inflation, he will have a balance of $576,100 in 2011 dollars in 24 years when he is ready to retire.
Maxing out Harry’s RRSP means there is no money left over for their child’s education. Since the mortgage will be paid off roughly a decade before retirement, they can easily reduce their monthly mortgage payment by $208. That would free up $2,500 a year. Doing so would mean it will take almost exactly one more year to pay off their house, assuming the rental is sold. The freed-up money would allow maximizing the RESP, gaining the $500 annual Canada Education Savings Grant, for annual $3,000 total contributions. With that rate of inflow of money, the RESP would grow to $49,540 in the 15 years before the child is ready for post-secondary education at age 18.
Year 4 (2014) The couple’s growing financial assets require an allocation and risk-management strategy. They can use a conventional allocation of 60% stocks to 40% bonds in their portfolio. Rather than try to pick specific stocks and bonds, they can diversify their holdings via mutual funds or exchange-traded index funds. Or they can seek an investment company or perhaps a portfolio manager who offers a good long-term record and relatively modest annual fees below 1.6% a year for stock funds and below 0.9% a year for bond funds.
Year 5 (2015) It is time to renew the mortgage on the house. It is likely that rates will have risen from today’s levels at near-historic lows. The ability to write off some interest against rental income will soften the blow, however. Harry and Felicia will need to decide if they want the peace of mind that goes with locking in a rate or what is usually the lower cost of just taking the floating rate of interest. At a rate of 5.5% on an outstanding balance of $260,175, their monthly mortgage cost with 16 years remaining would be $2,032. Or, if they maintain payments of $3,483, the mortgage would be paid off in eight years when Harry is 49, Mr. Moran estimates.
The Longer Term
It is difficult to estimate retirement income after age 65. However, assuming the couple has $576,100 in their RRSPs, that capital, generating 3% a year in returns after inflation, would produce $27,260 of income a year in the 33 years from Harry’s age 60 to Felicia’s age 90. Assuming Harry qualifies for full Canada Pension Plan benefits, currently $11,520 a year, and that Felicia gets a similar CPP benefit, that both receive Old Age Security, currently $6,291 a year, and that Felicia has an annual pension of $31,500, they could have $94,382 a year before tax in 2011 dollars each year. Pension splitting would avoid the OAS clawback that currently begins at $67,668 per person.
“This is a case in which the unknowns, such as Felicia’s health, contribute to the uncertainty of projections,” Mr. Moran says. “But we have used very conservative assumptions. I think that Harry and Felicia can move ahead with an assurance that their bills will be paid, their child’s post-secondary education will be financed, and their retirements turn out to be secure.”
After-tax monthly income $7,994
House $ 650,000, Rental property 585,000, RRSPs 20,000, RESP 2,400, Car 10,000,
House mortgage $606,000, Rental mortgage 384,000, Student loan 4,680,
Net Worth $272,720
House mortgage $ 3,483, Rental mortgage 1,637, Prop. tax house 286, Prop. tax rental 223, Rental expenses 200, Home utilities, phones 250, Home renovations 350, Food 400, Restaurant 50, Car fuel, repairs 200, Car & home insurance 200, Life insurance 50, Travel 173, Entertainment 150, Clothing & grooming 150, Student loan repayment 167, Charity, gifts 25
TOTAL $ 7,994
(C) 2012 The Financial Post, Used by Permission