I recently did a deep financial delve into a retirement plan for a couple I know and thought that this would make a great case study for an in depth discussion around retirement planning when it comes to your home and future financing needs.
Before we delve into our case study, I want to start by saying that my favorite retirement planning strategy involves setting up a HELOC to 65% of the value of the property in advance prior to retiring. This will give homeowners access to the maximum amount they can borrow against the house on a revolving basis with no interest charged until the time they require the funds, which could be 10 years down the line. Clients will qualify for more HELOC limit prior to retirement based on their working income than they will qualify for after retirement once income is reduced to pension and savings. Once clients have retired and are working with reduced income, we are subject to different borrowing solutions and lower maximum amounts. If you are thinking about retirement in the coming years, now is a good time to call your favorite broker to strategize about how best to tap into your homes equity to give you access down the line.
We are going to call our couple Jim (67m) and Susan (65f). Jim and Susan live in Edmonton, Alberta in a mortgage free bungalow valued at roughly 330,000. Jim and Susan are your typical hard working baby boomer generation. Jim was a tradesman and Susan was self employed most of her later career, neither has any company pension plan and so they are retiring now, much like the vast majority of their generation, with a reliance on CPP/OAS and their own savings to get them through.
The question? How to increase their monthly income utilizing their home to ensure they have a comfortable retirement and do not need to downsize from their home prematurely.
The idea they came to me with is a common scenario, build the basement into a suite and rent it out for additional monthly income, a solid plan for many homeowners. I presented to them a second option, a reverse mortgage annuity payment to top up their monthly income using the existing equity in the home. Let's explore both options.
Building a rental suite along with other needed repairs was priced out at $70,000. The home is a small 900 sq foot 50's built bungalow in a lower priced neighborhood in the city, but a neighborhood that may see the benefit of gentrification in the next decade. With a current value of approx. 330,000, building a suite in the basement would need to increase the value of the property to over 400,000 for the investment to be worth the cost, which in their market currently would not be the case. The funds would be borrowed resulting in interest costs and a small mortgage payment with a traditional loan, or a higher interest bearing loan with no payment via a reverse mortgage means that the valuation increase would need to keep up with the cost of the interest on the initial investment in order to make sense long term.
Renting out the suite means that rental income would then be claimed on their tax returns and taxable on the net rental income. They estimate a suite income of approx. 1000-1200/month for a small 800 sq ft basement suite in their neighborhood.
In Alberta, the difference in income tax on 12,000 of income in their tax bracket is approx. 3000/year. So on the extra 12k of income, they would be paying 3k of income taxes giving them a net of 9k of rental income, an extra $750/month.
Another consideration is that when turning a basement into an income generating suite is that the square footage of the suite technically becomes rental use and is no longer exempt from capital gains tax. Accountants will argue that the higher percentage of the overall sq feet of the property that is now a rental the higher the likelihood is that the CRA will come knocking for unclaimed capital gains. For this property with the basement suite area making up over 40% of the overall sq footage of the property it is a risk that they could be on the hook for further taxes down the line when selling the property. Potentially low risk, but still a risk. This is an area of much dispute on whether it would actually be enforced by the CRA, however, with capital gains being a topic of discussion in parliament over the last few years and with the current CDN debt levels coupled with a host of other initiatives being rolled out to encourage income suites to be built, this could be an area that the government decides to target in the future and should merit some consideration of potential future tax implications for our retired couple.
This would also bring with it the extra work of finding tenants, along with the question of whether it will be rented every month of the year or if there will be months of vacancy, repairs etc. that might mean less income or additional expenses like increased home insurance costs. The addition of the suite would trigger a higher property tax valuation increasing the property taxes on the home as well. If the couple were to finance the project through a traditional mortgage, a 70k mortgage at today's interest rates over 30 years would give them a payment of roughly $350/month. This would eat into the $750 net rental profit after taxes giving them only 400/month extra income to supplement their retirement. This was not their ideal scenario, but one they felt was all they could do to top up their income in retirement.
Let's explore the reverse annuity solution.
Reverse mortgages come with heavy scrutiny it seems, mainly due to some misconceptions about the program. The reverse mortgage solutions we have in Canada are quite different than the ones in the states. The loan here is registered against the title and the interest accumulates against the title and is paid out when sold. The lenders in this category have a strategic way of determining the maximum amount a client can borrow against the house based on their age, gender (ladies do live longer and are expected to be in their home longer than men), type of property and the appreciation rate for the location of the property. They use these factors to ensure that the property will appreciate in value enough to outpace the cost of interest that is accumulating against the title. There is a guarantee that no matter what the house sells for in the future, the debt is wipe out from the sale meaning the property will not go into short sale and no debt will be passed down to the clients or their families if the house does not sell for enough to cover the debt. In many instances, in areas with higher annual inflation of house prices, the homeowner has more equity in 10 years time due to inflation of value despite the extra debt accumulated against it.
For our couple, let's break down the math on their borrowing options with this product.
For their location and property type/value they can borrow currently up to 144,500 against the property right now. That could be increased in future if property values increase, but let's assume for right now they only borrow up to the 144k.
Reverse mortgages can take place as lump sum withdrawals or as monthly annuity payments and for this couple, we want to do a small combination of the 2 things. We are going to take a small 20k lump sum payment up front to do some of the more urgent repairs to the house as well as topping up the monthly income by $1000 for the remainder in an annuity. In this scenario, interest is only applied to the debt as it is taken which greatly reduces the amount of interest applied to the loan.
By taking the money as an annuity, it gives us 124 months of income top up (just over 10 years). At a modest 3% annual inflation rate, the home in 10 years time would be worth approx. 456k. The interest accumulated would be roughly 105k plus the amount of 144k borrowed over the 10 year period, which would leave the couple with just over 200k of equity in the home still at which time they would be considering downsizing in their late 70's. There is also the possibility of an inheritance during that time which would give them the option to pay off the balance owing, build the income suite at a later time when the cost might make more sense for the valuation increase in their neighborhood or save the inheritance funds to top up income after the 10 year mark.
There is also no income tax on the annuity, as these are non-taxable funds, similar to a refinance and equity take out meaning all $1000/month is in pocket spending money for the couple. The property retains it's principal residence status on the full property value meaning no capital gains applicable on the sale for the basement suite portion and they do not need to worry about tenants, suite repairs or other hassles that come from maintaining a rental unit.
The trade off...
This option does only buy them around 10 years if the inheritance does not come in, which means they would be either needing to reduce their monthly cost of living quite a bit in their late 70's, or reevaluate their living situation at that time if they still required the additional income. In contrast, the rental suite would continue to generate roughly 400-750/month in additional income past the 10 year mark depending on which route they financed it.
For Jim and Susan, they were ecstatic at the idea of not losing the basement space to a tenant, particularly when the home is already quite small. They were also not looking forward to the idea of finding tenants and managing a suite. Keeping the home as it is with a few minor repairs and putting the money into their standard of living instead meant more to them so they could enjoy the next 10 years of retirement with some time in the sun each winter. They also felt they could use the 1000 tax free income each month much more than the taxable rental income route which could be unreliable for every month of the year if there is vacancy etc. In the end, the lower stress option of taking the annuity made more sense for them at this stage.
There are no right or wrong answers when planning for retirement, as long as you make a plan. What works for one couple will not be the same solution that works for another based on a lot of factors. The important thing is to have options and weigh out what might work best for you, your risk profile, your family and your lifestyle.
If you have any questions about this or any other mortgage related topic, feel free to reach out to discuss your options at Jill@JillMoelleringMortgages.com or 780-720-4034.
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