Some retired clients are house-rich but cash-poor. The easy answer is to downsize.
But your client may prefer to keep his or her current home, either to live in or as an investment. Your client may particularly like his or her house and garden, be comfortable with the neighbourhood’s mix of shops and recreational facilities, or have family and friends living nearby.
Alternatively, your client may believe that real estate offers a better – and safer – investment, particularly in the current economic environment with unsettled financial markets.
If your client doesn’t want to sell, there are other options. One is a reverse mortgage, in which the client takes out a mortgage on the house, in which he or she has substantial equity. The trade-off is regular income now in exchange for lower equity in the house.
Financial advisors are not generally enthusiastic about reverse mortgages. They prefer that retired clients live within their means, and avoid adding to their debt at this stage in their lives. In addition, the income from a reverse mortgage doesn’t extend indefinitely into the future. It will be limited by the amount of equity held in the house.
Still, this is an option that can be made to work for some clients. One way to reduce the impact of the new debt, for instance, is to use life insurance to cover the cost of paying off the reverse mortgage upon the client’s death, as opposed to using the proceeds of a sale to cover the debt.
For many clients, becoming a landlord can be preferable. But clients who choose this route should be carefully advised about the trade-offs. The time, costs and general inconvenience of becoming a landlord are not inconsequential. Does your client want to be woken at midnight because something has broken down?
As Adrian Mastracci, president of KCM Wealth Management Inc. in Vancouver, notes: “Lifestyle is very important when people are in their ’60s and ’70s.”
However, renting out space in the home is an option that works for some people. Tim Cestnick, president and CEO of WaterStreet Group Inc. in Burlington, Ont., has had clients who have taken in students for part of the year, usually renting out only a room in their home. This option isn’t as demanding as conventional renting. The issue of terminating the arrangement is far less complex, as these tenancies fall under different rules than most landlord/tenant relationships. And for some clients, the social aspect can be welcome. Clients who live near a university or college are ideally situated for this option.
Cestnick also knows of people who have rented space for storing boats or cars. This option doesn’t generate much income, but sometimes a little extra can make a big difference.
For most people, the best option is a more conventional rental arrangement in which they rent out a self-contained space in their homes. In that case, most advisors recommend maintaining clear physical boundaries between the renter’s space and your client’s. Sharing a bathroom or kitchen can be very difficult.
Here are some points to discuss with clients considering renting:
– Fully renting a residence. If a house is fully rented, it may lose the exemption from capital gains taxes for a principal residence. In this scenario, the Canada Revenue Agency (CRA) deems that the house is sold and reacquired as a rental property, and any appreciation thereafter is subject to capital gains taxes.
A four-year exemption to this rule is allowed if no other property is designated as the principal residence, net rental income is reported and no capital cost allowance (CCA) is deducted. A letter must be attached to your client’s income tax return for the year in which the rental begins, describing the property and stating that he or she wants subsection 45(2) of the Income Tax Act to apply.
– Partial rental of a residence. It is possible to retain the full capital gains tax exemption on the principal residence while also renting out a portion of it. The proportion of the rental use must be small relative to the use as a principal residence. In addition, there must be no structural changes made to make the space more suitable for renting. No deduction for CCA is permitted.
There is no fixed rule as to what portion of the space can be rented out. In most cases, clients may rent out about 25% of the total square footage of their home. Fifty percent is likely to raise red flags with the CRA, says Cestnick, and there may even be issues with 40%.
If your client needs to make structural changes in order to rent or wants to rent a significant portion of the residence, then capital gains taxes may apply to the rental portion, based on square footage or the number of rooms rented out.
– Tax deductions. Rental income must be declared, but many expenses can be deducted against this income. This includes mortgage interest, heating fuel, electricity, insurance, property taxes, landscaping, and repairs and maintenance.
Deductions are not allowed for capital expenses that provide a lasting benefit, such as vinyl siding on a wooden house; replacing a separate asset that isn’t part of the house, such as a refrigerator; or repairs that improve the property beyond its original condition, such as replacing wooden steps with concrete ones. If only part of the house is rented, the expenses need to be pro-rated to the percentage of the rented space.
Cestnick notes that clients need to be careful with deductions for mortgage interest. If a client borrowed to acquire a rental property and decides to make the rental the principal residence and rent out the home, the principal residence’s capital gains tax exemption could be lost. That’s because the interest on the new principal residence is deducted against rental income.
– Sales taxes. GST or HST doesn’t have to be charged/remitted unless the annual rental income is $30,000 or more. IE
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