Couple must transform real estate into income
In Alberta, a couple we’ll call Jesse, 53, and Esther, 51, have focused their thoughts on early retirement. They see themselves migrating away from their jobs, his in a consulting business in the oil industry, hers as an administrator in a large company. They take home $9,000 a month. They have one child in their mid-20s who is financially independent. Their problem: Their wealth is almost all in real estate that generates no income. Their goal — swap land for two homes, one in Canada, one someplace warm.
Their question is straightforward: “What must we do to retire within a year or two? We would like to have a modest home in Canada for six months of the year and another home south of the border. We’d want $ 6,000 a month after tax in retirement? Can we get that level of income by 2019?”
Family Finance asked Mathew Hall, a portfolio manager and financial planner with Exponent Investment Management Inc. in Ottawa, to work with Jesse and Esther. His solution — sell enough property for cash to generate income which, with pensions, will produce $80,000 or more before tax.
“The couple has 80 per cent of their net worth in real estate and none of it generates income,” Hall explains. “If they do not turn real estate into income, they will not reach their retirement target.”
THE CASH- FLOW DILEMMA
Jesse and Esther have put most of their money into their home, cottage and raw land with total combined value of $ 1.9 million. The balance of their assets is in $144,407 of mostly lockedin RRSPs, and $650,000 in Jesse’s business. They have no tax-free savings accounts. Esther has a company pension plan that will pay her $32,000 a year at 65.
Before retirement, they need to pay off a $400,000 line of credit used by Jesse’s business with a 2.7 per cent annual interest cost. That’s $900 a month without any paydown of the principal.
Jesse may be able to liquidate his company with a value of $650,000 through a sale of its shares. He can use an indexed lifetime capital gains exemption of approximately $824,000. So he could shelter all of the $650,000 in the business after he sells it.
Jesse and Esther must downsize their home and sell their cottage and land. The properties have a present value of $ 1,900,000. They have used the cottage for only five days in the last two years. It is financial dead weight that costs a lot in foregone income and renders slight service. If selling costs add up to 7 per cent for commissions, if the land and cottage sales are sold at their adjusted cost base ( purchase price plus improvements) and thus have no capital gains, they will have $ 1,767,000. $500,000 should be reserved for purchase of a condo in Alberta they would use half the year. What’s left for investment would be $1,267,000.
Their business assets, $650,000, would be reduced to $ 250,000 after elimination of the line of credit. The remaining financial assets add up to $ 144,407. Their combined financial assets after sale of real estate and the business would be $1,661,407. FUTURE CASH FLOW
That sum, growing at 3 per cent a year after inflation for the 44 years to Esther’s age 95 would produce $68,500 a year before tax, perhaps $5,000 a month after 12 per cent average tax, short of the couple’s retirement target. They could reduce the gap by taking CPP early in seven and nine years, respectively, when each reaches 60 at a high cost of a 36 per cent permanent discount on benefits.
That reduction would persist as long as they live, perhaps four decades. If their combined CPP benefits are the maximum $13,370 each at present levels and each gives up 36 per cent or $4,813 per year, then for 35 years the value sacrificed would be $336,910 without any com- pounding. It is a massive sacrifice just for accelerating benefits for five years. Of course, CPP is a life annuity with the word “life” as the critical word.
Cost savings would eliminate the need to take CPP early. With their present real estate gone, they would save $1,694 monthly property taxes and the $1,691 home repair reserve. The $ 900 monthly line of credit expense would also be gone. They could reduce clothing and grooming of $700 a month by half saving $350 a month, and get by with one car, saving perhaps $275 a month, cut $500 off the $1,200 monthly food bill, and take $200 off the $400 monthly restaurant bill, they would have monthly expenses of $3,390, well within their initial retirement income range. Yet if they add back $400 for fees for a condo they would buy and assumed property taxes of $267 a month and throw in costs of $200 a month for utilities and repairs, the adjusted spending would be $4,257 a month, still affordable on initial retirement income.
Assuming that Jesse and Esther each work to 65, they would have combined CPP benefits of $2,228 a month and combined Old Age Security benefits of $ 1,167 a month in 2017 dollars. That adds up to $3,395 a month or $40,740 per year before tax. Add $32,000 from her company pension and $81,500 in annuitized payments from the sale of their properties and business paid out over the 32 years from Jesse’s age 65 to Esther’s age 95 and they would have $ 154,240 per year. After splits of eligible income and 20 per cent average tax based on age and pension credits, they would have about $ 10,300 a month to spend, ahead of their revised expenses and sufficient to pay for condo costs in Alberta and to buy and maintain a vacation property someplace warm. Patience will have produced both financial security in retirement and the continuous summer they crave.
The middle ground between barely sufficient income at 55 and abundant income at 65 is to work longer, save more, and start with adequate income for planned spending. The problem — a two-country lifestyle with the costs of travel to get to sunny places, medical insurance outside of Canada, and potential implications for estate planning if the vacation property they own is in the U.S. is expensive. Taking on those costs will require building up assets or cutting costs now.