Lee, 60, and Mira, 64, sit on a pile of real estate wealth. What should they do with their rental properties?

Over their working years, Lee and Mira have amassed substantial wealth, much of it by making timely investments in real estate. It includes their family house in the Greater Toronto Area and three rental properties.

Both work in the private sector. Lee is 60 years old and makes $155,000 a year, while Mira is 64 and makes $90,000 a year. Their $2.25-million in rental properties have a combined $662,000 in mortgages against them and generate about $50,000 a year in net rental income before tax.

They have $380,000 in cash, $220,000 in guaranteed investment certificates and a non-registered stock portfolio of $400,000. They also have substantial assets in their various registered accounts.

The couple plan to retire this year and want to give their two children, both in their late 20s, $350,000 each for a down payment on a first home. “What is our best strategy for funding this?” Lee asks in an e-mail. “What is our optimal strategy to achieve our retirement spending goals and maintain financial security?” he asks. “Should we keep our three rental properties as an ongoing source of income?”

Lee has a defined benefit pension plan, not indexed to inflation, that will pay him $2,500 a month at age 60.

Their retirement spending target is $130,000 a year after tax, less than they are spending now.

We asked Kaitlyn Douglas, a financial planner at Wellington-Altus Private Wealth Inc. in Winnipeg, to look at Lee and Mira’s situation. Ms. Douglas also holds the chartered financial analyst designation.

What the Expert Says

“Lee and Mira have done everything in their power to ensure a successful retirement,” Ms. Douglas says – saving money, paying down the mortgage on their primary residence and diversifying with rental properties. Even so, there are a variety of circumstances that can affect the plan’s success.

The couple can meet their retirement goals in a number of ways, the planner notes, so she explores different scenarios and how they could affect the value of the estate.

Her assumptions include an inflation rate of 2.2 per cent, an average annual rate of return of 5.22 per cent and that Mira and Lee both live to be 95 years old. They continue to max out their tax-free savings accounts for the remainder of their lives.

The $350,000 gift to their elder child is paid from their bank account before year end. The $350,000 gift to the second child comes from their joint non-registered account some time before the end of 2027.

Scenario 1

Using the firm’s financial planning software and Lee and Mira’s $130,000 a year after-tax spending target, Ms. Douglas says that if they take Canada Pension Plan and Old Age Security benefits at age 65 and hold their rental properties for the remainder of their lives, their “goal coverage” – the likelihood of success of the financial plan – would be 136 per cent with $11.4-million of assets remaining. The final tax bill would be about $1.6-million, or 12.3 per cent of the estate.

Because Lee and Mira live in Ontario and own properties, their estate will need to be probated and there is a 1.5-per-cent probate fee.

“For this scenario, we can structure the withdrawals in a way that the tax-free savings accounts remain largely intact, with an estimated value of $3.4-million at death. If they name each of their children what is known as a contingent beneficiary, the assets can be passed on to them directly, avoiding probate and legal fees, Ms. Douglas says.”

“Withdrawing in this fashion could save the estate $5,100 of probate fees.”

Scenario 2

If they take their CPP and OAS at age 70 instead, all other things being equal, the goal coverage would be 138 per cent with $11.6-million of assets remaining. The final tax bill would be about $1.57-million, or 11.98 per cent of the estate.

Deferring CPP until age 70 gives the clients a 42-per-cent increase in their guaranteed benefit, and deferring OAS until age 70 gives the clients a 36-per-cent increase.

“Doing so allows the clients to draw down on their registered assets – apart from their TFSAs – sooner, lessening the impact of taxes for the estate and giving them a guaranteed rate of return larger than what we can comfortably assume they could earn otherwise,” Ms. Douglas says. Their estate will be left with about $210,000 more than if they took the government benefits at age 65.

Scenario 3

This forecast assumes Mira and Lee need more cash flow than anticipated – for example, $156,000 net annually, an increase over their initial estimate of $130,000. Their plan would still succeed, with 108-per-cent goal coverage and $8.77-million remaining in their estate. The final tax bill would be about $1.2-million, or 12.03 per cent of the estate.

Lee and Mira are currently earning $245,000 gross a year, or about $170,000 after tax from their employment, plus rental income of about $35,000 a year after tax.

“For a normal retirement plan, we assume that you can live on about 35 per cent less than your pre-retirement income,” Ms. Douglas says. “That assumption normally comes from the idea that you no longer have certain expenses.” In this case, they have paid off their home mortgage but they will be retiring with debt because they have three rental properties with mortgages. “So for them, it is possible they won’t see as large of a decrease in expenses in retirement,” the planner says.

They are also looking at travelling more in retirement. “If we assumed they needed $156,000 net per year, they will end up with $8.77-million remaining in their estate, of which all of that would be the value of their personal residence and their rental properties,” Ms. Douglas says. “In this case, their estate may need to liquidate some of their properties in order to pay the final tax bill.”

Scenario 4

Retirement planning is a series of guesses. Something that is not always considered is if one spouse dies earlier than expected, the planner says. “We ran a scenario where Lee dies too early, at age 75.”

This forecast incorporates the previous assumptions but has Lee dying at age 75. The goal coverage slips to 97 per cent. About $6.84-million remains in the estate with a final tax bill or $1.06-million or 13.42 per cent of the estate.

Mira would need to draw more income from her investments to meet the same income requirement. The amount left to their children if Mira lived until age 95 would be about $2-million less. Mira would need to consider remortgaging her rental properties, or selling one, in order to maintain the cash flow needed to support herself in retirement.

Other variables could also affect the couple’s estate plan. If their rate of return was two percentage points lower than forecast, the goal coverage in scenario 2 would drop to 112 per cent, in scenario 3 to 92 per cent and in scenario 4 to 85 per cent.

And if the stock market were to drop by 30 per cent and take four years to recover, the goal coverage in scenario 2 would fall to 125 per cent, in scenario 3 to 98 per cent and in scenario 4 to 88 per cent.

Lee asks if they should hold on to their rental properties. “With the threat of a higher capital gain inclusion rate looming over our heads, Lee and Mira could consider selling their rental properties sooner rather than later and investing the proceeds in an investment with more tax-efficient income,” Ms. Douglas says.

Client situation

The People: Lee, 60, Mira, 64, and their two children.

The Problem: Nothing, really, but they wonder how to finance the gifts to their children and how to best achieve their retirement spending goals.

The Plan: The money for the children comes from their bank account and other non-registered investments. Consider how various factors could affect the value of their estate.

The Payoff: The comfort of knowing they can easily achieve their financial goals.

Monthly net income: $14,165.

Assets: Cash $380,000; guaranteed investment certificates $220,000; joint stock portfolio $400,000; his TFSA $155,000; her TFSA $150,000; his RRSP $686,000; her RRSP $658,000; his registered pension plan $95,000; her defined contribution pension plan $113,000; residence $1,800,000; his rental $750,000; her rentals $1,500,000. Total: $6,907,000.

Monthly outlays: Residence property tax $675; water, sewer, garbage $60; home insurance $125; electricity, heating $200; maintenance, upgrades, garden $800; vehicle lease $725; other transportation $660; groceries $700; clothing $150; gifts, charity $225; vacation, travel $750; other discretionary $50; dining, drinks, entertainment $460; personal care $50; pets $25; sports, hobbies $150; health care $25; health, dental insurance $350; life insurance $30; phones, TV, internet $220; RRSPs $3,600; TFSAs $1,150. Total: $11,180.

Liabilities: Rental property mortgages $665,000 at interest rates ranging from 4.65 per cent to 5.3 per cent.

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Some details may be changed to protect the privacy of the persons profiled.