Carefully unloading properties key to real estate investor’s retirement plan

$2.289M

Awoman we’ll call Margie, 61, lives in B.C. Her only child is grown and gone. A real estate agent and property manager, she has focused her savings and investments on rentals. She has a $780,000 home, $2,289,000 in four rental units and financial assets of $135,500 — together they make up most of her total assets of $3.2 million. Her $481,374 liabilities are mortgages for the rentals.

Margie has put her faith and fortune into B.C. property with considerable success. She has hefty gains over costs and the returns on her rentals — that’s net rent divided by her equity — range from a modest 2.5 per cent to a robust 6.14 per cent. The properties provide annual gross income of $106,500. After expenses including debt service she has taxable rent income of $41,857. Over time, as her mortgages are paid off, her net returns should rise and she should also see some gains from price appreciation. They are good investments, but with virtually all of her savings tied up in them, they are also a major risk should the market deflate.

The pandemic is a real risk, too. Margie acknowledges that her rents could go down by as much as 15 per cent if tenants can’t pay because of COVID-19. She worries that her return on investment in the properties may not support her in retirement.

“Do I have enough savings and future income to retire now?” she asks.

In retirement she expects to begin at age 65, Margie will have been resident in Canada for 21 years out of 40 needed for full OAS benefits, currently $7,362 per year, at 65. That works out to $3,900 per year. The Canada Pension Plan will pay her $175 per month or $2,100 per year if she waits to 65 to start benefits. She expects to do charity work and to serve as an aide to disabled people.

Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with Margie.

PLANNING SALES

OF RENTALS

“The appreciation of properties in the B.C. market and falling interest rates over the last several years on her mortgages have been very good to her,” Moran explains.

“Where to go from here is the question. She says she is looking at selling all of the rentals within five or six years when management becomes too much of a chore.”

Margie needs to be careful: lurking behind the price appreciation are future capital gains that may be treated as fully taxable income because she is in the real estate business. She needs to take accounting advice on this risk, Moran cautions.

Margie’s net rental income, $41,857 per year before tax and $36,834 after 12 per cent average income tax, is sufficient to cover present personal spending of $29,712 per year or $2,476 per month.

In addition to potential rental income, CPP and OAS, Margie will have proceeds of her $16,000 Tax-free Savings Account and $49,500 in a taxable account and $70,000 in her RRSP. She can add the TFSA and taxable accounts to her RRSP for a one-time tax saving of about 30 per cent and have $135,500 in her RRSP. In four years to retirement, that capital, growing at three per cent per year to $152,510. Annuitized at three per cent after inflation for the 30 years from her age 65 to 95, it would generate $7,554 per year.

When Margie decides to sell one or more properties, her reportable income even with the profits treated as capital gains and subject to tax on only half the actual gains will cause her annual income to increase dramatically. That will put her into OAS clawback territory which begins at $79,054 at present. The OAS clawback calculation looks back two years, so if Margie does want to sell, she should not wait to 65 or 64. Selling sooner rather than later will reduce the clawback, though not eliminate it, Moran explains.

BALANCING SALES AND ALTERNATIVE

INCOME

Margie wants to be rid of her rentals before she becomes too old to tend them. Assuming present valuations hold, then excluding the $780,000 value of her home, she could gross $2,289,000 less 5 per cent selling costs, net $2,174,550. Take off $481,374 mortgages and she would have $1,693,176. Take off $100,000 for income taxes on property gains of about $400,000 and she would have $1,593,176. Invested at age 65 to pay out three per cent after inflation for 30 years, that capital would generate $78,915 per year before tax. Selling one property per year would cut taxable gains in each year and thus limit tax exposure.

Margie could decide to keep her most lucrative rental. It has an estimated present price of $950,000 and a $336,383 mortgage. Its net rent, $37,704 produces a yield on equity of 6.14 per cent per year. However, retention of this choice asset is contrary to Margie’s plan to end her career as janitor and rent collector. We’ll assume her best rental fetches its value when sold. She will keep her $780,000 home.

ESTIMATING RETIREMENT INCOME

Assuming that Margie starts retirement at 65, her annual income from her existing financial assets, $7,554, plus $78,915 from former real estate, total $86,469 plus $3,900 from OAS and $2,100 from CPP would total $92,469 per year. After 20 per cent average tax and a loss to the OAS clawback, which begins at $79,054 in 2020 and takes 15 per cent of sums over that trigger point, net $2,012, she would have $72,000 per year to spend. Margie would still have her mortgage-free $780,000 home representing about 30 per cent of her net worth.

With no further mortgage expenses, Margie would have substantial discretionary income. Assuming that her $2,476 present monthly cost of living is unchanged, she would have $3,500 per month for other spending or investment. That money could form a legacy for her adult child and/or for good causes she favours.

Margie will be financially secure in diversified assets, her retained home, and government pensions. She will be free to pursue good deeds in her retirement.

DO I HAVE ENOUGH SAVINGS AND FUTURE INCOME TO RETIRE NOW?