Unprofitable real estate and not much else
Jack, as we’ll call him, lives in B.C. He has two financial lives: One as an engineer for an environmental research company; the other as a landlord. He brings home $10,422 per month based on his salary and annual bonuses, which are not guaranteed. He has two rental properties that pay $3,700 per month before expenses, but bleed money after deductions for interest, taxes and other costs. Now 53, he wants to retire in five years. He wonders if funding his money-losing rental condos is wise.
Jack’s balance sheet is unusual. He rents his own dwelling, an apartment, from a family member and pays below market rent of $900 per month in exchange for doing chores. He also enjoys many free meals with the family. Jack worries he lacks the savings to retire. He has just $81,000 in his RRSP, including his employer’s defined contribution plan; $5,000 in his underfunded TFSA, no non-registered cash and $313,000 of mortgages and lines of credit.
“My rentals, which are most of my capital, have generated a lot of capital appreciation for me, yet they lose money every month. What should I do to make my retirement work?” Jack asks.
Family Finance asked Graeme Egan, head of CastleBay Wealth Management in Vancouver, to work with Jack. “He pays below market rent for his own living space, has minimal financial resources beyond his two rental properties and he is subsidizing the cash flow rentals with other income,” Egan explains.
Jack’s two rental condos require monthly debt payments of $3,486 on two mortgages and a line of credit.
INCREASING FINANCIAL ASSETS
The plan for now is to sell Condo 1. It has a $58,000 fixed-rate mortgage and a $90,000 equity line of credit. The total, $148,000, is a little less than the other condo’s debt of $165,000, but Condo 1 was his home for several years. That makes the gain eligible for the principal residence exemption, which will reduce the taxable capital gain.
Selling Condo 1 for $720,000, less five per cent selling costs, would net $684,000, a gain of $499,000 over the $185,000 he paid 15 years ago. Jack lived in the unit for 12 years, so the gain would be reduced by the principal residence exemption, which recognizes personal use of the property and adds one more year. Therefore 13/15ths of the gain, about 87 per cent, is exempt. That would leave $65,000 subject to capital gains tax. Half of that is taxed, so tax at perhaps 25 per cent average rate, would leave a bill of about $8,000.
Subtracting another $148,000 to repay the mortgage and line of credit would leave Jack with $528,000. These funds, invested at 3 per cent after inflation in a TFSA to the allowable limit and the rest in taxable accounts for five years would grow to $612,000. If that sum is annuitized by calculation — not by purchase of an actual annuity — it would support payments of $30,000 per year for 32 years to Jack’s age 90.
Jack has $81,000 in his RRSP at present and contributes $785 per month plus $675 through an employer-sponsored registered plan for total contributions of $1,460 per month. If the present balance of the RRSP (we’re including the employer plan for simplicity) grows at 3 per cent after inflation for five years, it would have a balance of $187,000. If that sum continues to earn three per cent after inflation, it would generate $9,172 per year for the next 32 years at which time all capital and income would be exhausted.
Rental property 2, with a $720,000 estimated value and a $165,000 mortgage, requires $1,920 of monthly mortgage payments with 8 years left on its amortization. The condo fees are $350 per month and there are $175 of other costs. If nothing else changes, this would leave positive income after costs deducted from the $1,725 present monthly rent of $1,200 per month or $14,400 per year after the mortgage is paid in full. If Jack raises payments to $2,950 per month, then the mortgage would be paid in full in five years at 58, the threshold for his retirement. Jack can do this by shifting travel spending, now $1,250 per month, to the mortgage for five years.
RETIREMENT INCOME
At age 60, the earliest date for application, Jack can expect monthly Canada Pension Plan benefits of $570, which is 64 per cent of his age 65 estimated CPP benefit of $890. At 65, he could add Old Age Security benefits of $7,160 per year or $597 per month.
Adding up the sums for age 60 retirement, Jack could expect an annual income of $30,000 per year from capital released from sale of rental Condo 1, $9,172 from his RRSP, $14,400 from rental property 2, and early CPP benefits of $570 per month or $6,840 per year. The pre-tax total at age 65, $60,412 per year taxed at an average rate of 17 per cent, would leave him with $4,178 per month. He could add $597 monthly OAS at 65 to raise monthly income with a potential pension income adjustment from converting his RRSP to a RRIF of $4,775 per month.
Present allocations of $10,422 would drop by $3,486 with elimination of two mortgages and the line of credit, $550 in condo fees and taxes by sale of Condo 1, $1,470 by ending RRSP savings and $458 by cutting TFSA savings for total monthly savings of $5,964. He could thus spend about $4,460 per month.
The $315 monthly surplus would allow travel he must skip to get the mortgage on Condo 2 paid before he retires.
Jack’s annuitized RRSP income and annuitized income from sale of Condo 1 would end at age 90, but he would have annual rental income of $14,400 from Condo 2 and $14,000 per year of combined CPP and OAS benefits, all in 2018 dollars. If he sells Condo 2 three decades from now, assuming two per cent annual appreciation to $1 million after capital gains tax, it would see him through his days.