5 Common Misconceptions About Financial Planning

1.  You Don’t Need A Financial Advisor

What this really translates into is ‘help and advice are not worth paying for’. However, the vast majority of us rely on the skills of specialists to give us guidance and provide their services. Ask yourself this, would you perform your own appendectomy? Draft your own legal documents? How about re-wire the electrical panel in your home?  Maybe change the brakes on your car? Assuming you choose to attempt any of these tasks yourself, do you think you will do the job as well or better than a professional? More importantly, do you have the time and the expertise to get the job done right? Without proper education and training, attempting any of the above is either incredibly risky or reckless, possibly both. Strangely, for some people the thought of paying a professional to help them make sound financial decisions and develop healthy financial habits seems unreasonable. Independent research, as well as academic studies have proven that those who seek out professional financial advice are not only wealthier, they also have better saving habits and are more confident in their ability to meet their long-term financial goals. Isn’t that valuable?

2.  Financial Advisors Aren’t Trustworthy

It’s hard to say where this notion came from. Certainly the media plays a part and undeniably there have been cases of unscrupulous financial advisors. But individuals with a lack of ethics are not unique to the financial industry. There’s an abundance of vocations that have seen their fair share of misconduct; doctors, lawyers, police officers, teachers, mechanics, politicians - just to name a few. Nevertheless, in the eyes of some, the behaviour of a handful of financial advisors seems to have reduced the entire profession to be viewed as dishonest. Determining the trustworthiness of a financial advisor isn’t as hard as one might think. There are a few simple things you can do to help weed out the bad ones. First, perform a background check on the advisor's registration with the Canada Security Administrators, this will confirm who they work for and that they are who they say they are. Next, find out if there are any previous or outstanding disciplinary actions against them through the Ontario Security Commission. If the advisor has any credentials, like a Certified Financial Planner designation, you can contact the organization they are held with to confirm that the advisor is in good standing. Finally, and most importantly, talk to people. Request references and be sure to ask a lot of questions. If you still aren’t satisfied, don’t be afraid to ask for a few more – if the advisor is trustworthy they should be able to give you as many as you need.  Finally, use your judgement. If something doesn’t feel right then move on and find someone else.  Your financial advisor should be someone you implicitly trust; there is no room for doubt.

3.  Big Banks Are Best

Banks play an important role in our economy. They are the backbone of our financial system and it couldn’t function without them. Nevertheless, just because a bank handles your chequing account or holds your mortgage doesn’t mean that they need to be the ones to provide you with financial planning and advice. It’s conceivable that the investment recommendations that you receive from the bank may be biased. How so? Sales quotas and proprietary investment products aren’t necessarily designed for the benefit of the client, and in some cases they can potentially be a conflict of interest. If you are working with someone at a branch level, many times investment recommendations are made before there is a sound understanding of the client’s financial situation and their goals. With big marketing budgets and a significant presence in our communities, it’s understandable that many people find the big banks to be safe and familiar. However, like most public companies, banks tend to be accountable to one key group – their shareholders. You may be a ‘valued customer’, but your banks biggest focus is its bottom line. Shareholder happiness is a result of big profits. So from an investor’s perspective, is it better to be benefitting from that profit as a shareholder or adding to it as a customer?

4.  RRSPs Are A Type of Investment

“I don’t invest in RRSPs because they don’t earn enough”. Surprisingly, there are a number of educated people with a serious misunderstanding of what a Registered Retirement Savings Plan, or RRSP, actually is.  A RRSP is not an investment and it doesn’t have a rate of return. Think of a RRSP as a box that you are using to put your investments in. What you earn in your RRSP is based on what investments you put in that box. What is permitted as an investment in an RRSP varies, it could be a GIC, bond, stock, mutual fund, ETF or even certain mortgages (for a detailed list of what Canada Revenue permits click here). When your investments are in the ‘RRSP box’ any resulting investment income is not taxable. In addition, you are able to deduct the amount you put in the box from your taxable income in the year it was contributed. Depending on your income this can amount to some serious tax savings. When you eventually take the money out, which you will have to do at some point as there is a minimum withdrawal amount that starts at age 72, the entire amount withdrawn will be considered taxable income for the year in which you receive it. So, it is not so much a tax shelter, as many may believe, but really a tax deferral. The key principle is that you make contributions in your higher earning years and then withdraw your money in years when you have a much lower taxable income. As such, the RRSP can be incredibly valuable financial planning tool.

5.  Real Estate Is The Ultimate Investment

This is not a disagreement about whether or not to invest in real estate; it’s about investing EVERYTHING in real estate. If someone were to invest all their savings in one company it would likely be considered foolish. The pitfalls of this approach should be obvious - if your investment fails you put yourself at an incredible amount of risk to lose everything. Therefore one of the fundamentals of a sound investment strategy is to have proper diversification. In recent years we have seen the value of real estate skyrocket. This increase has led to many people putting most, if not all, of their savings in to the real estate market with the belief that it is risk-free and almost guaranteed to make them wealthy. The reality is that the real estate market is fraught with risk. First, consider the market risk – this is what the property is worth to a buyer. Much like the stock market the housing market fluctuates. What it is worth today is not necessarily what it’s going to be worth tomorrow. Next, there is the liquidity risk – which is the ability to find a buyer when you want to sell it. In some cases this can take years. Real estate is only worth what a buyer is willing to pay and only when they want to pay it. In addition, many don’t consider the ongoing costs associated with owning property – there is insurance, maintenance, and don’t forget the tax on any rental income and capital gains when the property is sold. When you do the math the rate of return on a real estate investment may not be as substantial as you had initially thought. Remember, technically your home is not an investment as the definition of an ‘investment’ is an objective to generate a profit. Even though the value of your home could increase between when you buy it and the when you sell it, your primary objective is to live in it. It’s also important to keep in mind that any profit from the sale of a principal residence is not taxable. Some real estate isn’t a bad thing; just make sure you’re not putting all your eggs in one basket.

It's not all boats and BBQ's... (Part 2)

In my last commentary I discussed the Globe and Mail's article “Six tax mistakes cottage owners should avoid”. While I addressed a few of the topics that were covered, I thought I would tackle the remainder before the cottage season closes out.

Changing the use of the property to income producing

While this may seem like a great way to generate income from your investment, it also has its drawbacks. The article draws attention to the fact there must be a disposition of the cottage on the date that the election to be income producing property is made. If you are eligible and choose to claim the principal residence exemption, this transaction may not have any immediate tax consequences - I explained the basics of a capital gains exemption on a principal residence in my previous entry. However, from that day forward until the sale of the cottage or your death you will be liable for paying tax on the annual rental income produced and any capital gains, if there is an increase in value in the cottage. Keep in mind that you can’t make a principal residence exemption with any other property for the period that you claimed on the cottage, i.e. if the cottage was elected as your principal residence from 2000-2015, an increase in the value of any other potential primary residence during that time would be taxable gain.

Selling the cottage to the kids for less than fair market value

This is a BIG mistake and can carry some serious tax consequences.  The simplest way of explaining it, assuming you aren’t using a capital gains exemption, is that you, as a seller, are taxed on what the cottage is worth at the time of the sale and NOT what you sold it for, if it was sold for less than fair market value. Your children, the buyers, will eventually be taxed based on what they paid for it and NOT what the cottage was worth at the time of the sale.  The result is double taxation and it can be a significant amount depending on the sale price and appreciation of the property.  For example, let’s assume that the fair market value (FMV) of your cottage is $500,000, you originally paid $300,000 and have decided to sell it to the kids for $400,000.  Canada Revenue Agency will consider there to be $200,000 of capital gains (FMV of $500,000 – original purchase price of $300,000) even though you only received $100,000 in capital gains. Your children will have a purchase price of $400,000 even though you paid tax on a sale price of $500,000.  Assume the children sell the cottage a few years down the road for a FMV of $600,000, they will also pay tax on $200,000 of capital gains (FMV of $600,000 - original purchase price of $400,000).  Essentially, between you and the kids, there will have been capital gains of $400,000 when there was only a true appreciation of $300,000 on the property. Even when you consider that only 50% of capital gains are taxable – that still equates to $50,000 of taxable income that never existed. As the article points out there are strategies to accomplish selling the cottage to your children for an amount that is less than fair market value without the double taxation, however you should sit down with financial planner to get specific advice about your circumstances.

Losses

As a personal use property you cannot claim losses - period. As a rental property losses can be claimed, but this type of use will limit your ability to claim the principal residence exemption. Before you decide to operate the cottage as a rental property you should discuss the benefits and drawbacks with your accountant and/or financial planner to determine if it makes financial sense for you.

Purchasing or inheriting a cottage can be a serious financial responsibility. For many it is well worth the expense as countless lifelong family memories are created there.  Hopefully, by avoiding the mistakes that I have discussed you can keep the memories and your money!

It's not all boats and BBQ's...

As the summer is now upon us I thought it would be a good time to talk about recreational properties. I will reference a few of the points raised in the Globe and Mail article “Six tax mistakes cottage owners should avoid”. I am going to expand on some of the issues the author addressed so you have a better understanding as to why they are important.

Claiming a Principal Residence

I want to focus on the first two points of the article: tracking capital improvements and corporate ownership of a cottage. To provide some background on the matter, Canada Revenue Agency (CRA) allows you to claim a property as a principal residence to take advantage of the capital gains exemption – in essence you don't have to pay any tax on the increase in the value of the property when it is sold. So, if you own a cottage and a home it is inevitable that at some point you will pay tax on the appreciation of one of those properties. From a tax efficiency standpoint, the goal is to minimize how much is owed when that time comes. To do so will require a careful analysis of the financials of both properties, which can include the original purchase price, capital improvements, acquisition and disposition costs, market value and the type of ownership.

Tracking Capital Improvements

The first point of the article stresses the importance of tracking capital improvements on your cottage, or any recreational property for that matter. First, let’s determine what a capital expense is. In the eyes of CRA, a current expense is one that generally reoccurs after a short period. For example, the cost of painting the exterior of a wooden property is a current expense. Whereas a capital expense generally gives a lasting benefit or advantage; for example, the cost of putting vinyl siding on the exterior walls of a wooden property. Renovations and expenses that extend the useful life of your property or improve it beyond its original condition are usually capital expenses.

Cost vs. Market Value

So why is it important to track these expenses? Well, the additional costs of any capital improvements will increase your Adjusted Cost Base (ACB) on the property. What is an ACB? In simple terms it is the original purchase price in addition to some subsequent expenses you have incurred – items like capital improvements, legal fees, real estate commissions and land transfer tax. When selling or gifting the property, the difference between the ACB and the Fair Market Value (FMV) is used to calculate your capital gain – of which 50% is taxable. In other words, if you increase your ACB you will have less tax to pay when the property changes hands. When you consider the increase in the cottage real estate market in Ontario and the expense of maintaining a cottage, especially one that requires a lot of updating and repairs, tracking capital improvements can have a huge impact when it comes time to sell.  If you aren’t taking in to account capital improvements it could be a very costly mistake! 

Corporate Ownership of a Recreational Property

The second point in the article referred to the ownership of cottage by a corporation. This is generally not a good idea from a tax standpoint. Corporate ownership of cottage results in the loss of eligibility for the primary residence capital gains exemption, as previously discussed. You may think that because you don't live at your cottage full-time that this doesn't matter. However, in some instances it may be more beneficial for you to claim your cottage as your primary residence as it could have higher tax consequences than your home. Of course, this would need to be analyzed on a case-by-case basis.

Cottage Use is a Taxable Benefit

If you are the owner of both a home and a cottage, you can designate either property as your primary residence when you sell one of them. Allocating the capital gains exemption between two properties can be complicated and is definitely a subject for discussion with a tax professional. Another concern in corporate ownership of a cottage is the potential for a taxable benefit. CRA could view any personal use of the cottage as a taxable shareholder benefit. What does that mean? Well, whatever the going rate for rent is for your cottage (or one like it) will be considered a benefit to you that you must pay tax on at your top rate. So, if a similar cottage in your area cottage would generally cost $4000 to rent per week and you have a 40% marginal tax rate, spending a week at the cottage could potentially cost you an additional $1600 in tax. If your goal is to avoid a tax when you sell or gift the cottage to your children or other family members, then perhaps you should consider the use of a trust. I will talk about this next month. Until then, be safe and have a fun time at the cottage!

If you are a cottage owner we would love to hear from you. Have you been tracking capital improvements on your cottage? Is your cottage under corporate ownership? Please feel free to ask questions or leave your comments below.