“Financial Checkup” is an ongoing series that discusses financial planning options. In this issue, Investment Executive speaks with Terry Ritchie, a registered financial planner, trust and estate practitioner, and partner with Transition Financial Advisors Inc. of Calgary and Phoenix, Ariz.; and Scott Starratt, certified financial planner, Canadian investment manager, portfolio manager and investment advisor with Richardson GMP Ltd. in Calgary. Caroline Rheaume, lawyer and vice president of wealth and estate planning with Richardson GMP in Montreal, also provided information for this article.



The Scenario: david and
Anne are interested in buying a U.S. vacation home, given the relatively high value of the Canadian dollar, the low value of U.S. real estate and the low but soon-to-rise interest rates.

The couple are both 60 years old and just retired. David’s indexed pension — currently $90,000 a year — will cover their living expenses in Toronto, where they own a home worth about $800,000. They have good medical, dental and vision benefits as part of David’s retirement package and have purchased long-term care insurance providing $6,000 a month between them for 250 weeks. Both partners will qualify for full Canada Pension Plan benefits at age 65.

David and Anne have a combined portfolio worth about $1 million, including RRSPs of $200,000 for David and $300,000 for Anne. They are wondering about the viability of buying a condo in the U.S. valued at US$200,000 and selling it after 15 to 20 years. They would expect investment income to cover all expenses related to the U.S. property, including travel and out-of-pocket costs while living at that property for about four months a year. They like Arizona, but would be happy to consider Florida or any other area.

The couple has three children and eight grandchildren and would like to leave about $500,000 in today’s dollars to each of their children.



The Recommendations: Ritchie believes David and Anne can afford to buy a U.S. vacation home for US$200,000 and still be able to leave $500,000 in today’s dollars to each of their children. But Starratt thinks the couple might have to lower their estate goal, partly because he’s assuming a 6% annual average return after fees vs Ritchie’s 7%. Also, Starratt suspects the couple will have to pay 25% more — US$250,000 — to get a place that provides them with the mid- to high-end lifestyle they enjoy in their Toronto home.

One way to afford a US$250,000 home, Starratt says, would be to pay some of the couple’s U.S. expenses out of David’s pension income ($7,500 per month) — specifically, US$3,000 a month when they are in the U.S. That, Starratt believes, is about equal to what the couple would be saving in Canadian expenses while in the U.S.

If David and Anne follow Starratt’s recommended strategy, they would need to put aside $300,000 to generate sufficient U.S.-dollar income to pay their annual U.S. expenses. Subtracting that $300,000 plus US$250,000 for the U.S. property and US$20,000 to furnish that home from their current $1 million in assets, they would be left with $430,000 in “other” assets, including RRSP assets. Starratt is assuming the couple will need US$10,000 for annual expenses — including property taxes, condo fees, insurance and property management — plus US$5,000 for each month they live in the U.S. Starratt is assuming these expenses will rise by 2.5% a year, vs Ritchie’s 3.1% annual inflation assumption.

Under the couple’s original plan, they would have to put aside $500,000 to pay U.S. expenses, leaving only $230,000 in “other” assets ($1 million minus $500,000, and minus another US$220,000 for the U.S. property and furnishings). Starratt thinks $230,000 is barely enough of a cushion, given the possibility of unexpected expenses related to two homes, David’s and Anne’s health or their children’s circumstances.

The other option is renting. Assuming that costs US$3,000 a month, Starratt says, David and Anne would need to put aside $400,000 to generate sufficient income to cover U.S. expenses for four months each year. However, if they took the equivalent of US$3,000 a month out of David’s pension income, they would need to put aside only about $250,000.

In contrast, Ritchie thinks David and Anne can get a satisfactory home for US$200,000. He notes that prices have declined dramatically in the U.S. — particularly in Florida and Arizona.
@page_break@Ritchie suggests renting for a few years if the couple aren’t sure where they want to be. But, given their intention of buying, he recommends putting US$200,000 in a savings account or a short-term, fixed-income instrument now, while the exchange rate is somewhat favourable. He notes that there are many factors that can affect the value of the C$, not all of which would push it upward.

Choosing the right area in which to live is a matter of lifestyle, says Ritchie. He recommends visiting www.zillow.com, which provides information on the value of specific U.S. properties.

Property taxes differ among states. Florida’s are relatively high because the state doesn’t levy personal income taxes; and property taxes are even higher for non-residents, who pay about 50% or more than residents. Florida is currently one of the few U.S. states with a higher rate for non-residents, but other states may follow suit.

Buyers also need to check out condo fees or homeowners’ association fees, if applicable. These are assessments that pay for common-area expenses. Clients will need to find out how much is in the HOA kitty, the history of fee increases and whether there have been or are likely to be special assessments. Ritchie says these fees are usually US$100-US$300 a month; Starratt’s experience suggests US$220-US$700. As a rule, the higher the fees, the more services are provided, which can include keeping an eye on a property when the owners aren’t there.

Neither Ritchie nor Starratt advises renting out the property once purchased. Ritchie says the couple would need to rent out the property for at least six months to make renting worthwhile, and that wouldn’t be easy because David and Anne will want to be there during the winter months, when other Canadians, who are the easiest tenants to find, would also want to be there. Renting also involves filing a U.S. tax return in addition to a Canadian return because the couple would be earning money in the U.S. (A foreign tax credit for U.S. taxes paid can be claimed on a Canadian’s income tax return.)

A major issue is how the ownership of the U.S. property is structured. There are many options, including trusts, corporations and partnerships. However, neither Ritchie nor Starratt thinks David and Anne should pursue these options; you need to have about $5 million in assets, says Ritchie, to make these strategies worthwhile.

Rheaume agrees, saying the various options are complex and that one should be undertaken without consultation with a cross-border tax expert. She does suggest, however, that David and Anne have wills and property powers of attorney drawn up in the state in which the U.S. property is located, in order to facilitate disposing of the property.

U.S. estate taxes are not being charged in 2010, but will return in 2011. Joint ownership would lower the portion of estate taxes that has to be paid upon the first death, but only if it is “true” joint ownership. Upon the filing of a U.S. estate tax return, the U.S. Internal Revenue Service would require proof that each partner has paid his or her respective portion. A copy of each party’s cancelled cheque would be sufficient proof.

In 2011, U.S. estate taxes could be imposed on Canadians with worldwide assets of $1 million or more. Credits under the Canada/U.S. tax treaty are available for married couples to reduce these taxes. Some states, such as Arizona and California, charge their own estate taxes. Others, such as Florida, don’t — currently, at least.

There is also the issue of U.S. capital gains tax, which is 15% this year and will rise to 20% in 2011. When a property worth US$300,000 or more is sold in the U.S., Ritchie adds, 10% of the gross proceeds are withheld for tax purposes.

A major risk in buying a U.S. property is movement in the exchange rate. This risk can be avoided if sufficient funds are in U.S. investments. However, Starratt thinks such a strategy will result in too much U.S. exposure. If David and Anne stick to buying a US$200,000 vacation home and paying all the U.S. expenses out of investment income, about 64% of their financial assets would need to be U.S. investments.

Starratt recommends a portfolio with an overall asset mix of 5% cash, 40% fixed-income and 55% equities. He would put only 7.5% of the equities portion in U.S. dividend-paying equities, pools or exchange-traded funds. The rest would consist of 25% in individual Canadian large-cap stocks, 10% in Canadian small-cap equity mutual funds, 7.5% in international equity funds and 5% in alternative investments such as private equity or real estate. The fixed-income portion would be in individual bonds, pools and ETFs.

Ritchie gets around the danger of too much U.S. exposure by recommending purchases of Canadian and international equities and fixed-income in US$-paying ETFs. The portfolio he suggests would be 40% fixed-income and 60% equities.

Within the equities portion, 25% would be Canadian, 25% U.S. and 50% international; this would include small-caps, emerging markets and alternative investments such as hedge funds, gold, oil and gas, and other natural resources. Most of the investments, including fixed-income, would be in ETFs, but there would probably be some use of institutional mutual funds.

Starratt’s fee would be 1.5% of assets in this case; Ritchie charges 1% on the first $1 million in assets, with a minimum fee of $10,000. IE