FAMILY FINANCE

Leveraged borrowing can make an entrepreneur’s dream of buying first home in Vancouver a reality.

In one sense, Bob Dreumon*, 33, and his wife, Ann, 37, have been living an enviable life in Vancouver. His business, a management consulting company, grosses $40,000 a month, while her work as an office administrator brings home $5,000 a month, although she is currently on maternity leave, receiving $2,000 a month. The best part from a financial point of view: they’re not paying rent while they stay in the home of Ann’s parents, who are away for six months at their Arizona condo. A run-of-the-mill house in greater Vancouver has an average price of $1.2 million, which would tie up at least $2,500 a month that could otherwise earn 2.5% in fixed-income investments. But they want to put down roots in a home of their own. The problem: How to afford an upscale house with a price tag of $2 to $2.5 million?

The Dreumons have the means to do it, for their $1.3-million net worth would support a large down payment. Bob could also take more income or dividends from his company to pay for the mortgage. “They have a large annual savings capacity of as much as $250,000,” notes Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B. C. “They have the ability to buy a home. It is just a question of how they do it and what taking so much money out of their personal and Bob’s company savings will do to affect their future.”

There are certainly cheaper ways to live in Vancouver and B.C. But buying, say, a $2.4-million house with a conservative 25% down payment would take a monthly mortgage payment of $7,895 at 2.3% for 25 years, plus another $1,000 or so a month for utilities, taxes and upkeep. There is also the lost opportunity cost of investing the down-payment amount. Alternatively, they could use all their available capital to buy a house. The company’s coffers would be bare and they would incur hefty income taxes at the B.C. rate of about 44% for cashing in their $95,000 of RRSPs. Bob and Ann can afford it, but the cost will be as much as $120,000 a year taken from potential distributions from their business.

We’ll assume that Bob and Ann do not deplete their savings. Doing so would expose them to many risks, such as a business slump leaving them with virtually no cash in the bank. Besides, Bob has been working since he was 18, saving diligently and living frugally. He drives a beaten-up $8,000 car and limits dining out and entertainment combined to $400 a month. Making a down payment of $600,000 would leave them $695,000 in their accounts, including $117,000 in their Tax-Free Savings Accounts.

But there is another way. Bob could cash out only his taxable accounts and the TFSA to use for a large down payment, then use his equity in the house as collateral for a loan to repurchase those investments or others, which would generate income and perhaps capital gains. If the investments make, say, 3% after inflation and Bob pays 2.6% on his mortgage, he would clear a modest 0.4%. This is sometimes called the Smith Manoeuvre and it should only be done with the advice of an accountant to ensure compliance with tax law.

What makes the deal work is that the interest on the home-equity loan used to buy

investments generates income that is tax deductible, creating an after-tax gain of a few percentage points on the deal. The risk is that Bob could be squeezed by a higher rate when he rolls the loan over. However, with his high rate of savings, he could have the loan paid off in a couple of years.

With the remaining $695,000 generating a 3% annual return after inflation, they easily have the capacity to set up a Registered Education Savings Plan for their recently born child, Tess. If they contribute $2,500 a year and obtain the Canada Education Savings Grant bonus of $500 a year to a present limit of $7,200 per beneficiary, the plan would have about $67,250 when Tess is ready for post-secondary education at age 18.

Bob has $ 95,000 in his RRSP and can contribute up to 18% of his net business income to a limit of $25,370 in 2016. If he works 32 more years to age 65 and if his income remains the same, then using 2016 dollars and holding the contribution limit constant in the same 2016 dollars, he could build his RRSP up to $1.62 million, assuming a 3% return after inflation. We’ll disregard Ann’s accumulations for she is thinking of not returning to work. If this capital were paid out for 30 years until Bob is 95, it would generate $80,100 a year before tax.

Ann has a defined-benefit pension plan with her present employer. If she quits, she can take out the commuted value (the capital needed to generate benefits) of about $300,000 and invest it, which could generate $9,000 a year indefinitely or a $14,900 annuity paid out for 30 years with a 3% annual return. We don’t know if Ann would leave the money in the plan, nor the period of compounding before payout. We’ll use the $9,000 figure to be conservative. If each adds $5,500 a year to their TFSAs for the next 32 years and they grow at 3% a year, they would have $896,000. That would generate $44,400 a year before tax until Bob is 95.

All of this depends on Bob’s good fortune with his business. At present, he takes dividends from the business. Taxes on dividends are lower than those on earned salary income. As a result, he is not participating in the Canada Pension Plan. He should take a mix of salary and dividends, Moran advises, to maximize his allowable CPP contribution. A half-and-half salary-and-dividend allocation is a conservative way to deal with taxes, Moran says. If Bob maintains contributions, he could have half the CPP maximum or $6,555 a year at age 65.

Adding up these income components gives the couple $132,640 a year before tax, plus whatever income they might obtain from Bob’s business or capital from the sale of it. Add in their various retirement income sources at 65, including Old Age Security for each at $6,846 a year at 65 (assuming the government resets the eligibility age), and that gives them a retirement income of $147,192 a year. Assuming TFSA payouts of $44,400 a year, no significant loss to the OAS clawback, which is triggered at about $73,682 a year in 2016, and an average income tax rate of 18% on splits of eligible pension income, they would have $10,058 a month to spend. If Bob sells his business profitably, the sum would be higher. They would have financed Tess’s education and bought a house they can afford, even in Canada’s most expensive housing market.