By Suzanne Sharma
On their fourth wedding anniversary, in October 2010, Naveed and Renata Kattan* decided to buy a cheap property south of the border. They paid US$300,000 for home in Fort Lauderdale, Fl., which had been valued at almost double that sum before the 2008 real estate crash.
Their down payment was US$15,000, and they took out a 30-year mortgage at 4.64% on the balance. Unlike Canadian mortgages, U.S. homebuyers secure a loan once for the term of purchase, unless they refinance. Although current 30-year rates are 3.85% (and 3.22% for a 15-year amortization) they haven’t yet refinanced.
Their monthly payment is US$1,468. That was fine when the loonie was on par with the greenback, but they’re now paying C$1,838—an extra $370 hit to their monthly income. Worse, if the loonie continues to drop, say to 65 cents, their monthly payment would balloon to C$2,258.
The Kattans worry about how they’ll continue to pay their outstanding U.S. mortgage. They don’t have the option to deduct mortgage interest or other costs from their taxes since they’re not U.S. citizens and don’t live there long enough to trigger residency status. They also don’t generate any rental income from the property.
Each spouse is employed full-time; they have a gross family income of $163,000. They owe about $8,500 total on credit cards and a personal loan, and have close to $250,000 outstanding on their primary residence in Ajax, Ont. Renata and Naveed have maxed out RRSPs and TFSAs. They’re both in a conventional mix of global and Canadian mutual funds, with a 30% fixed income component.
So what’s the best option for their U.S. property?
Naveed and Renata should’ve done more research before buying the property, says David Chalmers, financial advisor at Nicola Wealth Management in Vancouver. “They should’ve made it a reasoned decision, not emotional, and thought about some of the things that could go wrong.”
This includes what happens if the loonie drops, the impact on estate taxes, and how much owning the property would cost daily.
In their current situation, he adds, they have three options: continue to service the loan, rent the property to tenants, or sell.
Keeping the home
The couple’s monthly payments are now more than $1,800, and that’s not including carrying costs, such as maintenance and insurance, notes Chalmers.
“Maybe the cost of owning this property is really going to be $3,000 a month, or $36,000 a year,” he explains. “If they spend 100 days there, which is probably at the outside because they’re both working, that’s $360 a day” – not much less than a decent hotel in the area.
Given they only spend a few weeks there, and with the loonie so low, it’s “exorbitantly expensive on a per-diem basis.” The pair nets about $120,000 a year after taxes. “This sounds like a lot, but more than one-quarter of all the money they’re earning is going to support this property.”
It doesn’t make sense to cash out their TFSAs to continue servicing the loan, he says. That extra money would only buy time; eventually, they’d be in the same situation.
“So, holding this property and just servicing the loan is not a good option,” says Chalmers.
Renting to tenants
Renting would be a better option, he says, because Naveed and Renata could reduce costs by whatever amount they get in rental income.
They could rent permanently to a family, or weekly to vacationers. But if they choose the former, the couple will no longer be able to stay there themselves.
“Their dream of having a place to go to in Florida will not work out as well as they’d thought because the place they want to go to is always occupied,” says Chalmers.
Before moving forward, Naveed and Renata would need to research vacancy rates to determine how much rent they could charge.
And finding tenants could be challenging. The couple could hire a property management company to both screen tenants and handle maintenance and repairs. The cost can range from 10% to 25% of their rental income.
There also may be tax benefits, because after declaring rental income on their Canadian returns, they’d have the option to deduct expenses. “However, it’s likely there will be zero effect on their Canadian tax. The income and deductions will cancel each other out, or possibly they’ll make a very small profit.”
The third option is best. Since most U.S. properties have appreciated in value in the last five years, they’d likely profit if they sold.
Chalmers would tell the couple: “The drop in the Canadian dollar was bad news for you in terms of carrying costs. But it’s good news in terms of selling because even after paying selling costs and capital gains tax, you’ll still make money.”
Say the property sale gives them a US$300,000 capital gain. Taxed at the highest rate, they might pay $75,000 in capital gains tax. Naveed and Renata would still be left with a roughly US$225,000 return.
Moving the property into a trust is not a good option, Chalmers notes, because the couple would be deemed to have disposed of the asset. So they’d still have to pay capital gains tax, but wouldn’t have any proceeds from a sale to cover those costs. Plus, they don’t solve the burden to their household cash flow.
“So they should sell the property, take the profit and pay off the mortgage on their own home.”
*This is a hypothetical scenario. Any resemblance to real persons or circumstances is coincidental.