In 2002, Les Mallins and his neighbour, William Hurst, used the equity in their Toronto homes to purchase an aging commercial building in an up-and-coming area in Toronto’s east end. Mallins, a chartered accountant and Hurst, an architect, converted the building to lofts, which almost sold out in their first weekend of sales. The company has since become a multimillion-dollar success, with several more buildings either completed or in the works.

Mallins and Hurst have successfully done what many aging Canadians would like to do: monetize the huge value in their homes that two decades of escalating house prices have brought. But not everyone shares their entrepreneurial bent. And while those gains look good on paper, they do nothing to add to retirement savings and income.

“You can’t have a bedroom in Calgary and a living room in Atlantic Canada,” says Patricia Lovett-Reid, senior vice president with TD Waterhouse Canada Inc. in Toronto.

So, how do aging boomers access the wealth that is tied up in the family home and diversify their wealth? Common methods include downsizing to a smaller home, renting out all or part of their property and using reverse mortgages.

The Canadian real estate market has been on the upswing for several years, as long-term mortgages and low interest rates have made housing more affordable. As well, significant amounts of money have flowed into this country, especially from emerging markets such as China, India and Russia. In some markets, that has pushed prices higher, making Canada’s real estate market more attractive than the that of U.S., in which the market has been slowing. As well, U.S. immigration policies have become stricter, especially following 9/11.

“Canada has a very good image as a peace-loving nation and a very welcoming country when it comes to immigrants,” says Tina Tehranchian, a certified financial planner with Assante Capital Management Ltd. in Richmond Hill, Ont. “So, a lot of foreign nationals, people in the Middle East especially, feel much safer with their money being invested in Canada than in the U.S.”

But despite all the positives of investing in real estate, Tehranchian urges her clients to diversify. Real estate, like any other asset, has boom and bust cycles. “And this recent cycle we’re in is getting long in the tooth,” she says.

For advisors concerned about the concentration of risk on the part of clients who have most of their assets in real estate, there are options, including getting a home-equity line of credit and diversifying into good-quality stocks and bonds.

“Many advisors proceed with caution when looking at this, but it makes sense to at least have the conversation,” Lovett-Reid says. “You can’t eat a brick in retirement. So, if people need money, then this is an option to explore.”

The discussion advisors have with clients who are thinking of tapping their real estate assets has to revolve around the clients’ lifestyle goals and how much risk they’re comfortable taking on.

“We can’t just talk about the money; we have to talk about the emotion,” says Lovett-Reid. “Someone who has paid off their home may be averse to having debt.”

With those caveats in mind, here are a few ways to monetize real estate holdings:

> Leveraging. Leveraged investing using a home as security for a mortgage or line of credit is one option, but this must be exercised with caution. Warren Baldwin, regional vice president in Toronto with T.E. Wealth, a subsidiary of Toronto-based Jovian Capital Corp. , sets the parameters fairly tight when clients seek his advice on taking equity out of their homes to invest elsewhere. Although taxpayers are permitted to deduct the interest on loans that are used to earn income, the structure of such transactions is crucial.

“People screw it up,” he says. “They buy the smoke, but they don’t understand the sizzle. The sizzle is where they can get burned.”

Baldwin advises clients that borrowing against their homes to invest elsewhere should be done very carefully: “The Canada Revenue Agency is somewhat concerned with people borrowing to invest and may examine the steps of the process to make sure it follows all the rules. If you’re sloppy about how you do it, then you might get into some trouble.”

The CRA could deny the deduction for the interest expense. The CRA’s post-assessment review process can take several years, and if receipts for the interest can’t be provided, the interest deduction will be denied.

@page_break@In particular, the investment must be traceable directly from the lending institution to the borrower’s account, and from there into the investment portfolio, if the investor is claiming a deduction on the loan interest.

Says Baldwin: “If you don’t have it tracked and linked — ‘The money went from my bank to my bank account, and I wrote the cheque on the bank account and put that money into the portfolio’ — you could have the whole [interest expense] denied.”

Baldwin has clients who have taken money out of their homes for investment purposes and the advisor is pretty particular about the conditions under which he approves the strategy. He cites the example of a wealthy, dual-income couple with a paid-off home worth perhaps $800,000. On occasion, they take out a $200,000 advance on their home-equity line of credit at a rate of about 4.25% or 4.5%. With cash flow from income and bonuses, they can easily repay the loan. And they put their loan in an investment with a record of healthy gains.

But advisors must weigh clients’ comfort level with risk before any mortgage money is taken out, because there’s always the chance that they could take a loss on investments acquired by mortgaging their houses. “You could have a year in which your negative return is 10%, 15% or even 20%,” says Baldwin. “It’s quite possible — not probable, but quite possible. So, if you felt that losing $30,000 was going to cause you absolutely to have a meltdown, then we probably shouldn’t be doing it at this level.”

> The Smith Manoeuvre. For clients still paying off a mortgage, the Smith Manoeuvre is a strategy for making mortgage interest tax-deductible. Popularized by Fraser Smith, a retired advisor in British Columbia, it involves borrowing against the equity in a home and using that money to invest in the stock market or in mutual funds. The investor sets up a line of credit to start borrowing against the equity in the house.

“As you pay down the principal on the mortgage,” explains Tehranchian, “it opens up room in the equity line of credit that you can borrow against to invest.”

Although mortgage interest is non-deductible, interest on the line of credit — as it’s an investment loan — is deductible. So, if the client pays down $500 of principal on the mortgage, he or she can borrow that amount from the line of credit and invest it.

“The inves-tor’s total debt will always stay the same, but the mix [mortgage and line of credit] is going to change,” says Tehranchian. “As time goes on, they’ll have more and more tax-deductible debt.

“It allows you to dollar-cost average because if you do it consistently on a monthly basis,” she adds. “As you pay down principal [on the mortgage], you’re buying on a monthly basis into the markets, and usually that’s a good strategy for averaging the cost of your investments.”

But it means taking on added risk when it comes to investments, Teh-ranchian cautions, and it’s not for every client.

“You have to have the tolerance for it,” she says. “The longer your time horizon for investments, the easier and the safer you’re going to be.”

But whether the markets go up or down, clients are still on the hook for the interest payments on the equity line of credit. Risk-averse clients can find the process very unsettling, especially in a down market.

> Moving On Down. Despite the many predictions that boomers would want to downsize by moving to a smaller house or condominium, it appears that many are content to stay put because of social connections and familiarity with their neighbourhoods.

Tehranchian discourages clients who are considering this option to help fund their retirement. She points out that a 3,600-square-foot, $1-million home in the suburbs can cost the same as a downtown Toronto or Vancouver condo that’s one-third the size.

“Even when you’re downsizing, you’ll end up wanting a nice luxury condo in a nice neighbourhood,” she says, “which means you’d have to pay the same or more. It could be worth it. But, in terms of counting on the equity in your home to finance retirement, that should be left as the last option because, in most situations, it does not work that way.”

> Reverse Mortgages. Getting a reverse mortgage is an option for seniors who don’t want to sell their property. A reverse mortgage is a lump-sum payment that is secured by the senior’s home and is limited to a percentage of its appraised value, usually less then 50%. A reverse mortgage allows older homeowners to turn some of the equity in their house into cash.

But reverse mortgages carry higher interest rates than most other kinds of mortgages. And as the interest on the mortgage grows, the equity in the house declines. One of the benefits of using this option is that the income isn’t taxable. And the clients don’t have to pay back the loans until they sell their homes or move to other accommodation.

The downside is that the interest is usually quite a bit higher than for a secured line of credit, says Tehranchian.

“So, that debt is accumulated, because the interest is capitalized and the debt gets bigger and bigger the longer the reverse mortgage situation goes on,” she says. “Some seniors are very uncomfortable with having any kind of debt.”

As the equity in the home erodes, it won’t affect the borrowers’ lifestyle, but it can cause rapid shrinkage of the estate and it affects their children’s inheritance.

> Renting Out Property. Renting part of the house is another option that clients may want to examine.

One risk is the potential for damage to the property. Another is that many people who rent out part of their homes find that their privacy is compromised. However, some people, especially seniors living alone, like the idea of having other people around.

Another option, if clients plan to travel or live on a property in another country, is to rent out the house on a long-term basis. Clients can still treat the home as a principal residence, says Tehranchian, as long as they don’t claim any capital cost allowances, which is the depreciation for tax purposes on the portion of the residence that the client has rented out.

As long as the client doesn’t claim depreciation, they can claim the capital gains exemption on the principal residence when they sell. The income on the rental portion of the home must be declared, and clients can write off a proportion of the expenses for that portion of the property they are renting out.

It’s also possible to make an election that allows the principal residence to be rented out for up to four years without triggering the change-of-use rules. Those rules were designed to prevent property owners from claiming the capital gains exemption for a principal residence that they have converted to an income-earning property.

But the election rules must be carefully followed, and Tehranchian recommends consulting a qualified accountant before acting.

> Business Investment. The equity in a home can also be leveraged to invest in a business.

Mallins, the accountant who financed his foray into the condo business through the equity in his home, had bought his home in 2000. Two years later, the house had gone up in value by about $250,000, which was enough to remortgage it and put a deposit on his first condo conversion.

“I came to the table with nothing,” Mallins says, noting that the down payment on his house came from a home-purchase loan from his former employer. “I’m not sure if everyone knows the opportunities that are out there to take equity out of your house. But it should certainly never be done without fully thinking through what you’re doing. That’s everyone’s nest egg and part of their retirement plan.”

Brad Brain, a financial planner in Fort St. John, B.C., agrees. In the end, it will depend on what the client wants to accomplish.

“Ideas such as downsizing and renting may make financial sense, but that doesn’t mean that they are the right fit for an individual’s unique situation,” he says. “Emotions aside, an unbiased look at the math of leveraging isn’t always favourable.” IE