Jason Heath: There are unique tax, cash flow, and estate planning considerations for landlords in retirement
Some Canadians own rental properties as an investment strategy. While most are familiar with the implications of buying a property and earning rental income, there are unique tax, cash flow, and estate planning considerations in retirement.
Rental properties have similarities to a lucrative defined-benefit pension plan. An owner’s contributions (expenses) are generally tax deductible. The value (real estate price) grows tax-deferred over time. The monthly payments (rental income) are indexed, rising with the cost of living.
Real estate prices have gone up a lot in certain markets, and that may cause some people to think real estate is a better long-term investment than stocks. As an example, the composite MLS Home Price Index in Greater Toronto in January 2010 was $393,800. By January 2020, the price had skyrocketed to $836,800 — an increase of about 112 per cent.
By comparison, the S&P 500 was at 1,115 on January 1, 2010. By January 1, 2020, it had risen to 3,231. That is an increase of about 190 per cent for U.S. stocks. Canadian stocks, as measured by the TSX Composite, rose by about 45 per cent during the same period.
Real estate prices and stock market levels do not tell the whole story. Stocks pay dividends but they also have associated fees that can be more than two per cent paid to an advisor or through embedded mutual fund fees. Rental properties generate net rental income — the gross rent less associated expenses. Rental real estate is usually leveraged, as much as five-times if an investor puts down the minimum 20 per cent down payment.
So, which investment is better? If real estate price growth is modest, a rental property funded with a mortgage may provide a comparable return to a low-cost, balanced portfolio of stocks and bonds. In my opinion, they are just different ways to invest.
In retirement, it can be easier to withdraw money from an investment portfolio, but that does not mean a rental property cannot be used strategically to provide retirement income or capital.
A simple way that real estate investing can help fund retirement is as rental income increases, cash flow tends to increase as well. Ignoring interest rate increases, mortgage payments do not rise over time, or will end eventually, but rental income typically increases most years. A landlord can also increase their net rental income by increasing the amortization on their mortgage. As an example, a $100,000 mortgage with 10 years remaining at 2.5 per cent has monthly payments of $942. If the amortization is increased to 25 years, the payment would drop to $448, boosting cash flow. This could be a strategy to implement each time a rental property mortgage is renewed.
A rental property owner can also access capital from their real estate without selling. They can increase the mortgage to get cash in their hands without any tax implications. The interest paid on the additional funds is not tax deductible, however, if it is meant for personal use. The fact that the debt is secured by a rental property does not make the interest tax deductible, contrary to popular opinion. It is the use of funds that determines if interest is tax deductible. So, it is advisable for administrative purposes to have the bank segment the mortgage separately so that it is easier to track.
Selling a rental property in retirement is an option. If the property has been owned for a long time, there can be significant tax implications. The appreciation is taxable as a capital gain. The capital gain is reduced by the buying and selling costs like land transfer tax and real estate commissions. Renovations done over the years also increase the adjusted cost base and decrease the capital gain. If depreciation was claimed historically, a recapture of all previous capital cost allowance claims is also brought into income in the year of sale.
Capital gains tax can exceed 25 per cent for a large capital gain if the seller has a lot of other income in the year of sale. This presents an opportunity to try to minimize income or increase tax deductions at the time a rental property is sold. Selling a rental property after retiring, while in a low-income year, is a reasonable strategy. Another could be contributing to an RRSP in the year of sale. Net rental income is considered earned income for RRSP purposes, so rental property owners may accumulate RRSP room even after they have stopped working. RRSP contributions are only allowed up to the year a taxpayer or their spouse turns 71, so this strategy has practical limitations.
A retiree in their 60s has several decisions to make about their income, like when to start government pensions (CPP and OAS) or when to begin RRSP/RRIF withdrawals. If they plan to sell their rental property, planning the timing of other income sources is important in anticipation of a sale.
When a landlord dies, they are deemed to sell their rental property. The capital gains tax is based on the fair market value of the property on their date of death. A formal appraisal is not required but can be helpful. Because the capital gains tax can exceed 25 per cent of the appreciation, especially for a landlord who claimed depreciation on the property while it was owned, it is important to plan for eventual tax liabilities.
Whether a property is owned jointly with a spouse or is left to a spouse in the will of the deceased, the rental property can pass to the surviving spouse on a tax-deferred basis at its adjusted cost base. If the property is owned with or is left to another beneficiary, like a child, there will be tax to pay on the final tax return of the deceased.
If they have enough other assets, the tax may be easy to pay. If the tax is more than their other liquid assets like cash and investments, this could present a challenge for their estate to pay the tax. The property may need to be mortgaged or sold to pay the tax, so this should be considered.
Should you buy a rental property to save for retirement? It is tough to anticipate whether real estate or stocks will provide a better return over the next 10 years. Both have merits. I suspect the next decade will see lower returns than the past 10 years for both asset classes.
Sometimes, there can be non-financial reasons to make investments. Some people may be more comfortable with real estate or understand it better. Others may prefer the liquidity and simplicity of stocks over the hassle of being a landlord.
As you approach or enter retirement owning rental real estate, consider the different options you have that can increase cash flow or access equity, while minimizing and planning for income tax.
Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto, Ontario. He does not sell any financial products whatsoever.