National Post (National Edition)
Wealth-building ideas in an era of low rates, possible higher taxes
Taking a snapshot of the world can sometimes present ideas that are especially valuable based on the current environment.
We like to look at the entire financial picture — investments, tax, debt, real estate and insurance — when doing this, since it can take combining a couple of disciplines to create a wealth-building opportunity.
Today, the key underlying themes are: very low interest rates; the risk of increasing tax rates, especially capital gains tax; and another opportunity to profit from an eventual global demand recovery
With all that in mind, here are the five wealth-building ideas to consider.
Flow-through shares and specialized flow-through shares
In a nutshell, flowthrough shares take advantage of federal and sometimes provincial tax credits that support exploration and development. They work particularly well for individuals with taxable income of more than $250,000 and for those wishing to do larger ($25,000-plus) charitable donations.
The net results of flowthrough shares are generally very positive after tax, but they also spin off a lot of capital gains because of the way they are structured for individuals. This is all factored in, but if capital gains tax rates go up in 2022, it will definitely weaken the benefits of personal flow-through shares in the future. But if you happen to be carrying capital losses, flow-through shares are an even more compelling investment, even if your income is less than $250,000.
One weakness of traditional flow-through shares is that you have to hold onto a mining stock for a period of time that you may not want to take on. To solve that issue, there are specialized flow-through shares that allow you to sell the shares right away at a loss, but it eliminates all unknowns and investment risk. As a result, you know to the penny the benefit that you will receive from purchasing flowthrough shares versus not doing so. Because of potential increases in capital gains tax rates in 2022, 2021 may be the last, best year for this type of strategy.
Borrowing money to generate income
If you borrow money to generate income, the borrowing costs of those funds are tax deductible. If you borrow money on a home equity line of credit, you might be able to get a rate of prime or 2.45 per cent. If you are locking in a fiveyear mortgage, the rate can be around 1.35 per cent for a variable mortgage and 2.2 per cent for a fixed one.
If you are in the 50-percent tax bracket, and use these funds to generate income, your after-tax cost of borrowing is 50 per cent less than posted above. At its cheapest, your after-tax borrowing cost could be about 0.67 per cent. The question is whether you believe you can earn more than 0.67 per cent after tax on this borrowed money?
The funds can be used to buy an income property, maybe a condo or duplex that can be rented out. The funds can be used to invest in a variety of stocks, real estate income trusts, preferred shares and mortgage investment corporations, which have an annual yield of five per cent or more. In some cases, the income can be tax preferred.
None of these investments are without some risks, but when the hurdle rate is only 0.67 per cent, or even 1.67 per cent, the odds of building some wealth with the bank's money are certainly in your favour.
Investing in energy and financial services
Two sectors that have been undervalued for quite some time from an investment perspective are energy (old school energy) and financial services. These sectors have already had some very solid stock market growth during the past year, but we believe there is more growth ahead, especially since some have pulled back over the past couple of months.
From an energy perspective, even a huge player such as Suncor Energy Inc. is compelling: it is expected to have its fifth straight quarterly earnings increase; it is trading around $24, but was $31 just seven weeks ago; it has a forward price-to-earnings ratio of 9.4, from 24 in the summer of 2018; it has a dividend yield of 3.4 per cent and that translates into a payout ratio of just 32 per cent, suggesting a dividend increase is very possible; the stock hit $51 in July 2018 when the average oil price for that year was US$61.34, and its stock price is now around $24 when oil is US$68.50.
From a financial services perspective, Manulife Financial Corp. is a company that has underperformed for a while. It is trading in the low $24 range and hasn't been a great stock for the past dozen years. Having said that, there are a few things going for it.
It has a forward priceto-earnings ratio of just 7.5, a dividend yield of 4.7 per cent and a payout ratio of just 35 per cent. The company also has a pretty good record of raising dividends, so it wouldn't be a surprise to see a dividend increase in the coming year. It should also benefit from a post-lockdown economy for both mortality and disability reasons on the insurance side, as well as from a general increase in interest rates, which should benefit its net interest income.
Even if Manulife doesn't do a lot of price appreciation, a 4.7-per-cent dividend yield that is likely rising over time will certainly cover off a few bills, or your 1.35-per-cent to 2.45-per-cent borrowing cost to invest in the stock.
Both these stocks pay out Canadian dividends. In Ontario, if your net income is $200,000, your tax rate on these dividends would be 32.1 per cent. However, if your net income is $40,000, your tax rate would be zero. This leads to the next idea.
Making spousal loans
In Canada, you can gift funds to adults without any tax impact or attribution back to you. The exception is if the funds are going to your spouse, since the government wants to avoid pushing taxable income to a spouse with a much lower income.
Having said that, you can make a spousal loan. This is a demand loan that can be paid back at any time. The government sets what is known as the prescribed rate of interest at the time of the loan. Today, that rate is at an all-time low of one per cent.
There are two ways to really benefit from a spousal loan. The first is when one spouse is in a much higher tax bracket than the other due to employment income. You would then loan money to the low-income spouse from the high-income spouse, and have the funds be invested in the name of the low-income spouse.
The low-income spouse does have to pay (and report) the one-per-cent interest payment to the higher-income spouse, but that amount can be made up very quickly when one spouse is paying a tax rate of zero on Canadian dividends and the other would be paying 32 per cent.
The other way this works is if you are retired and, for a variety of reasons, one spouse ends up having significantly more non-registered investments in their name or when corporate dividends are payable only to the higher-income spouse. It could be from an inheritance or simply years of income where the funds were held in their name only.
For some income sources, such as pensions and registered retirement income funds (RRIFs), the income can be split 50/50. However, in this situation, you would want to use a spousal loan to better balance the income.
Using life insurance in a corporation to minimize taxes
This one is a little more complicated, but it is one of our favourite tax minimization strategies. Briefly, if someone has or will have sizable investments in an active corporation or holding company, one of the big challenges is to get money out tax efficiently. Using life insurance for a portion of the assets, we have had situations where the individual will be at least 100-per-cent better off after tax on the insurance proceeds than not using the insurance, whether the person dies in five years, 25 years or 50 years.
What this might mean is that if the after-tax insurance proceeds coming out of the corporation after 25 years is $1 million, the after-tax equivalent of investing the funds at 5.5 per cent a year for 25 years (rather than putting those same funds into life insurance) would be less than $500,000.
Finally, always remember interest rates move, sectors go in and out of favour and tax rules evolve. These changes mean there are always ways to look at the current landscape and find ways to benefit. Today is another one of those days, and these five strategies are looking particularly good at the moment.