Is the Financial World out of Sync?

I hope everyone had a good summer. At times our great weather almost made me forget we are living in a COVID-19 world.

And then I looked at the daily health reports, the economy and the markets - and remembered that we are truly living in a time of pandemic. From a financial perspective, wherever you turn the signs are there: yet the stock and real estate markets seem to be vastly out of sync with the stark economic reality of the pandemic world. Let’s explore that disconnect. 

Bay Street and real estate vs. main street

At the beginning of the pandemic, I like most of you personally felt the financial stress and dislocation caused by COVID.

But I also felt my clients’ concerns and worries, which were extremely distressing over the first couple months. Together we worked to solve the financial challenges related to their businesses (which were often temporarily shuttered), and to understand the government programs – which were released at what seemed like a daily clip and often revamped later on. During this initial period, the stock market fell 35% or so, as one might have expected, and the housing market ground to a halt.

However, after the initial drop off the cliff, the stock markets started a steady climb back to their January 1, 2020 levels, and the housing market heated up. I am aware of two cases in the Toronto area where not only was the sale price of houses substantially over the listing price, but there were so many buyers that the seller had the buyers write letters explaining why they want the property.

This return to form in the financial and housing markets continues — even as wide swathes of the Canadian population struggle. Millions of people are receiving the Canada Emergency Response Benefit (CERB). Small business owners can’t restart their business or are working just to break even or keep the lights on for better days. Employees across the country have been temporarily laid off or have lost their jobs.

Let us review the possible reasons for the financial and housing markets’ strength in a weakened economy.

Stock markets

Over the years, the stock market has taught us that we usually cannot predict its direction. As a result, it is generally best to hold your portfolio and even buy when everyone is running for the exits.

Yet COVID investing seemed different. While some of us were smart enough or bold enough to buy at the pandemic’s deepest lows in March (not me), most people needed all their discipline not to liquidate their equity holdings in some part. I am in no way a market historian, but this pandemic crash looked scarier. The world’s economy came to a standstill and the economic destruction seemed like it would take years to overcome.

So why did the markets turn on a dime and go bullish? Why have they showed no sign of flagging? Why do they continue to defy the larger economic trends? The reasons are varied, but based on articles I have read by financial experts and the numerous discussions I and my client's have been in with investment managers, these are the top ones I have read or heard:

1. “Don’t fight the Fed.” It’s an American phrase referencing the Federal Reserve, but the point is valid in Canada too. The Bank of Canada (like the Fed) has provided an unprecedented liquidity injection to keep the market afloat.
2. Markets reflect a long-term view. They have discounted our current economic and social issues for an expected brighter future.
3. The markets have built in a vaccine discovery in the next 6-12 months.
4. Interest rates are so low that you must be in equities or you will have a negative absolute return after inflation in GICs and T-bills. This reason is put forth by investment managers in every conversation I have been involved in.
   
5. The travel, entertainment and retail industries do not have a significant impact on many stock market indexes.
6. Technology and healthcare have flourished in many cases during COVID, and these sectors make up a significant portion of the U.S. indexes that many Canadians invest in. (On the Canadian exchanges, Shopify has also helped carry the Canadian market rebound.) The stock market recovery reflects the success of technology and healthcare - not the health of the larger economy.
7. The larger companies have hoards of cash to keep them afloat and take advantage of companies with lesser balance sheets.
8. Some people have flipped from being scared of being in the market to having a fear of missing out on the rebound.

While the market has soared, some experts warn that the market is in a bubble of historic proportions. So, keep in mind, these are unusual times, and the market can turn around and surprise us to the downside just as easy as it can continue to climb.

In retrospect, maybe I should have seen the stock market bounce-back coming, but I clearly misunderstood. Based on the 8 reasons discussed above, clearly the stock market can be strong while the world’s economy is essentially shut down. But I have asserted only that I am blunt, not that I’m smart.

Housing market

One would have thought that many people would hesitate to purchase real estate during COVID-19 due to the uncertainty of their jobs and the economy. However, the housing market in Ontario and many parts of Canada has seemed impervious to the pandemic, which I would not have envisioned in late March.

The experts seem to agree on the below reasons for a strong housing market. I’d also like to say a big thank you to my colleague George Dube – a veteran real estate investor and accountant – for his insight.

1. Large shortages in the supply of homes and a relative abundance of buyers led to competition and bidding wars. On the supply side, many people just hunkered down and did not want to risk selling into a pandemic market.
2. Those who were fortunate to keep their jobs had fewer places to spend and decided in many cases to renovate and fix their current homes rather than purchase a new home, reducing supply.
3. Many people decided to purchase cottages rather than move to new city homes. If I can’t travel for vacation, people said, I want to have access to a cottage property. This is especially true while we still don’t know when COVID will recede and when we will see an effective vaccine. People staying in their homes reduced the inventory of homes for sale.
4. Interest rates are so low, so the cost of carrying a mortgage for the foreseeable future is extremely low and unlikely to change based on government economic policy.
5. The lack of activity in March and much of April led to a catch-up period releasing pent-up demand.
6. People concluded working from home is going to be the new normal in some fashion. They realized the money they had saved to eventually buy a home in the city could be redeployed to purchase a home in the suburbs or in a more rural area. This led to a spike in many areas outside big cities. While this moderate exodus would theoretically soften prices in urban areas, the fact is that the fundamentals in those markets are strong enough to keep prices high. It should be noted that this exodus from the cities has reportedly caused some softening in the personal condominium market, as many of the people looking outside the large cities would have been condominium purchasers.

All this being said, it is worth differentiating between housing and other real estate subsectors. For example, the retail and larger commercial office building markets are seeing the “expected” drop in demand given COVID, due to the loss of foot traffic and employees being told to work from home. On the other hand, in the industrial sector, the massive growth in online ordering has increased the need for space to accommodate logistics and warehousing.

So, is the financial world out of sync? I personally feel the answer is still at least a lukewarm yes, if you like me feel there is or should be some kind of direct correlation between the economy and the stock and real estate markets. But as I have noted above, the correlations can sometimes run parallel and may not intersect, so that may be a misguided view. We shall see in another year or two whether the stock and real estate markets got ahead of themselves, or whether this was just the first phase of even stronger markets. Interesting times either way.

The content on this blog has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The blog cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information on this blog or for any decision based on it.

Please note the blog posts are time sensitive and subject to changes in legislation.

BDO Canada LLP, a Canadian limited liability partnership, is a member of BDO International Limited, a UK company limited by guarantee, and forms part of the international BDO network of independent member firms. BDO is the brand name for the BDO network and for each of the BDO Member Firms.

Rental Properties - Everything You Always Wanted to Know, but Were Afraid to Ask

In August 2011, I posted a blog titled “The Income Tax implications of Purchasing a Rental Property”. There are 300 comments and answers on this post (so many that I added a note at the end of the blog a while back, that I would stop answering questions on this specific post). I recently read through the comments and realized there were several excellent questions that have probably been “lost” in the morass of questions. Today, I have decided to highlight some of the better questions. In some cases I have expanded my answers.

Questions and Answers Related to Rental Properties

Q: With respect to rental income being considered passive and therefore taxed at the high rate - is there are certain point or threshold when a real estate company's rental income is considered active and therefore eligible for the small business deduction? Is it still considered passive when you grow to a certain number of properties or employees?

A: Chris, great question, the answer is yes. A real estate company would be considered a specified investment business and not eligible for the small business deduction. However, if the corporation employs greater than 5 full time employees, the income is deemed active and eligible for the small business rate of 15.5% or so depending upon your province. I have clients with multiple corporations, each owning a single rental property. If one of the corporations has more than five employees, who really are also employees of the other corporations, it may be problematic to claim the active tax rate in that corporation. You may be able to utilize a management company, however, where the rental properties are residential, they cannot claim back the HST they pay, so a management company may not work.

Q: This is the best rental property tax blog that I have seen for Canada (Bloggers note: I just selected this question because of the opening sentence to this question :).

My question is about net loss and the government. My husband and I make over $300K in combined income. We own a 1.3 Million dollar home and it has no mortgage. We are looking at purchasing a property which is close to 2 million dollars and finance the whole amount (based on LOC and new mortgage). It will clearly generate a net loss even if we get the maximum rental income. We have done the math and the savings on taxes and a moderate appreciation of the property is well worth it. We currently have a condo rental

which has generated a modest profit for the past 5 years. Does the government care if you generate a loss for an extended period of time (over 10 years)? Thank You!

A: Flattery will usually get you everywhere. But in your case, it will only get you a link to a Torys LLP newsletter. Although the link is dated, it should answer your question.This is really a question on the "reasonable expectation of profit" doctrine.

The key comment in the Tory's newsletter is the following: “Essentially the court have held that where an activity is a commercial activity – that is, it does not have a personal element-there should not be judicial or CRA scrutiny of the taxpayers business judgment for the purpose of determining whether or not the activity is a source of income".

As per the comment above, commercial activities are problematic for the CRA to attack, so they have been going after taxpayers who claim losses with any kind of personal element.

Q: My husband and I have a duplex in both our names. Both units are rented out at this time. My husband is the sole provider for the family and I stay at home with the kids. My question is how do we claim the rental? Do we claim it 50/50 or does my husband claim 100% since he is responsible for the expenses etc.

A: Legally if ownership is 50/50, you must report the income 50/50. However, for income tax, there is the issue of income attribution. i.e.: whose money was used to purchase the property or was it a Line of Credit with both names. If your husband used his money and put the property in both your names, then technically all the rental income or losses should be reported by him. Although technically incorrect, many spouses seem to ignore the attribution rules and report income/losses on a 50/50 basis.
 
Q: Hi, I love your blog and how accessible you are, thank you so much for your contributions! I have a very old house that I have been renting for five years now. The roof has to be repaired or it will soon start to leak. We want to replace the roof with life-time guaranteed shingles. Is this kind of expense a current expense since it's required to maintain the current quality of the house or a capital expense since it also increases the value of the property?

A: Great question. Technically the CRA may say you have improved your roof by purchasing shingles that are better than the prior shingles or the lifetime guarantee makes them better than the prior shingles and thus the cost should be capitalized. However, I would suggest that the majority of accountants would likely expense the cost and argue this is purely a repair, but it is not 100% clear. 

Q: I purchased a revenue property in Quebec 5 years ago and I am planning on possibly selling it this year. Can I amortize the capital gains from the sale over 5 years? I am considering possibly selling it and buying another revenue property immediately afterwards. I.e. during the same year. I was told that if did do this then the capital gains from the sale of the property would not need to be declared since I am using the profit to buy another property. Is this true?

A: For capital gains there is typically a five year reserve available where all the proceeds have not been received on sale, see this example. In respect of the second part of this question, you are asking about the replacement property rules. These rules would not typically apply to rental property purchases and re-purchases, but relate to business properties replaced. This paper from CGA Magazine discusses the issue.

Q: I have a couple of rental houses and currently considering incorporating them to credit proof my personal assets. I understand that the rental income is treated as passive income so no benefit, but is there a difference if the rental property was sold through a corporation or held personally - i.e. can the capital gain be reduced capital gains exemption?

A: The capital gains exemption is not available on the sale of shares where the underlying asset is a rental property not used in an active business. The benefit of incorporation is pretty much creditor proofing and maybe some income splitting with your spouse depending upon the circumstances.

Q: Hi, Great blog. I purchased a 2 floor office condo (525k, 2800 soft) and its part of a 6 unit block of 2 floor office condos. One floor I rent out and one floor I use for my business. I can't find anything to indicate the value of the land for tax allocation. Do you think using the 10% rule of thumb would be appropriate in this situation and would a rule of thumb satisfy CRA?

A: Where there is no hard evidence to determine the allocation between land and the building, it would not be unusual for many accountants to use 10% for land related to a condo. That does not mean it is correct and that the CRA would not challenge the allocation, however, I have not seen the CRA challenge this.

Q: What are the tax implications of purchasing a home for myself and family to live in as our primary residence and renting out the basement. Would it be the same implication if we put an addition on the house but we still occupied more than 50%. Thanks.

A: This is what the CRA says, I think their response answers both your questions.

"It is the CRA’s practice not to apply the deemed disposition rule, but rather to consider that the entire property retains its nature as a principal residence, where all of the following conditions are met:

a) the income–producing use is ancillary to the main use of the property as a residence;
b) there is no structural change to the property; and
c) no CCA is claimed on the property.

These conditions can be met, for example, where a taxpayer carries on a business of caring for children in the home, rents one or more rooms in the home, or has an office or other work space in the home which is used in connection with business or employment. In these and similar cases, the taxpayer reports the income and may claim the expenses (other than CCA) pertaining to the portion of the property used for income–producing purposes".

Q: I have a question about % used for business on my tax return. We have a cottage rental property. We open it in the spring and close it in the fall. Out of the 16 available weeks, it was rented 12 weeks, vacant 1 week, and personal use for 3 weeks. The 1 vacant week was advertised for rent but we did not get a booking. The remaining 36 weeks a year, the cottage is not accessible, the roads are not maintained and the

cottage is not heated.

How do I calculate percentage used for business? Is it just the rented weeks (12) or available for rent weeks (13)? And in the denominator, can I use 16 weeks or do I have to use the whole year.

A: See the discussion in this paper about your issue.

The paper says this. “In the Morris case, the decided that the portion of the operating losses to be written off against income was the percentage that is was available for rent during the operating season. Since the cottage was frozen for a portion of the year and therefore not rentable, the expenses for that period of time were not deductible.

As a result of these decisions and others, the Canada Revenue Agency is taking the position that if you use the property personally and rent it out the rest of the time, your business use is only the period when you can "Reasonably expect to rent out the property.”

Keep in mind that this is the CRA’s view, I am sure lots of people do not necessarily agree with their position, but if you take an alternative position, you may be challenged.

As you will have observed from the above Q&A, some of the income tax issues that arise in respect of owing a rental property are complicated or fall into a murky grey area. I would suggest that if you own a rental property, you should probably have an accountant assist with your income tax return.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. Please note the blog post is time sensitive and subject to changes in legislation or law.

Income Tax Preparation Tips

As promised last week, here is a summary of the Tax Tweet Tips I posted last year (in many cases, expanded from the 140 character limit imposed by Twitter). I have updated these tips to assist you in preparing your 2013 personal income tax return

Tax Tips for Preparing your 2013 Return

1. If you sold stocks or real estate in 2013, ensure you have the original cost documents. 

Note: This issue is twofold. Firstly, you should always maintain stock purchase confirmations or the annual summary to substantiate the adjusted cost base of any stock purchases. You also must maintain the original reporting letter and statement of adjustments for any real estate purchase. Secondly, many people do not keep receipts (or they may have paid cash) to substantiate cost base additions to their rental properties or cottages. Without these documents, you may have a difficult time convincing the CRA that the adjusted cost base of your real estate is higher than the original purchase price.

2. Confirm your 2013 installment payments online. Alternatively, there is a summary of the 2013 installments you paid on the back of the 2014 installment reminder the CRA just sent you.

3. Interest expense related to your investment accounts is often missed. Check the bottom left of your T5 summary for the interest you paid during the year.

4. If you sold collectibles in 2013, such as coins, stamps and china, they may not be taxable if your proceeds were <$1,000.

5. Canadian residents who are also US citizens or Green Card holders must file a 1040 US return. If you are a Canadian resident earning Rental Income in the US, you must file a 1040NR.

6. Do you own shares in any delisted, bankrupt or insolvent companies? You may be eligible to file an election to claim the capital loss this year.

7. When filing a deceased parent/grandparent’s return, ensure you report any deemed dispositions of stocks or real estate.

Note: Upon passing, if property is not transferred to a surviving spouse, the deceased taxpayer is deemed to have disposed of their capital property at death as if they actually sold the shares or real estate. The determination of the cost base of that property can often be problematic to say the least.

8. File returns in the year your child turns 18.They may be eligible for some claims at 18 and others at 19 are based on their age 18 return.

9. If you sold capital property in 2013 that was held prior to 1994, review whether you elected to bump the value in 1994.

Note: In 1994 the $100,000 capital gains exemption was eliminated. However, you were entitled to make a final election to use your capital gains exemption on stocks, real estate etc. Many people forget they made such an election and that their cost base on certain property is higher, which reduces the capital gain to be reported. This election was used extensively by people on their cottages. So if your parents sold their cottage in 2013 remind them to check if they made the election in 1994.

10. Do you pay investment counsel fees to an investment advisor? If so, they are deductible.

11. If you have a Line of Credit for investment purposes, check your December, 2013 statement for a summary of the interest you paid in 2013 & claim the interest expense that related to your investments (you may have to apportion that expense if you co-mingle your LOC with personal expenses).

12. Did you own foreign property with a cost of over $100,000 at any time during the year? If so, you must file Form T1135.

13. If you sold a US stock in 2013, use the F/X rate from the year of purchase to determine the cost and use the 2013 rate for the proceeds. You have two choices. Either use the actual F/X rate on the day of purchase and sale, or you can use the CRA's yearly average rate however, you must be consistent.

14. Did you sell a REIT in 2013? Reduce the ACB by the return of capital from prior years.

15. Last tip. Don’t file your return late no matter what! There’s a 5% penalty + another 1% per month up to 12 months. Even if you cannot afford to pay the tax due, file your return to avoid the penalties. You can usually make arrangements with the CRA to pay off your tax liability over time if you provide reasonable terms of repayment.

Hiring The Blunt Bean Counter

This is the time of the year when I’m frequently asked by readers of The Blunt Bean Counter to provide individual tax preparation services. While it is truly is an honor to receive these types of inquiries, my tax practice at Cunningham is focused on corporate tax, estate planning and financial advisory.

Unfortunately, these days, Chartered Professional Accountants only have about 3-4 weeks to complete the majority of our personal income tax returns, because most of our clients T-slips do not arrive until early April. This circumstance has forced me to narrow the scope of my tax compliance practice and I typically reserve the time I do have available to prepare personal tax returns for the owner-managers of the companies that I service. Consequently; I am unable to take on any additional personal income tax return work for non-corporate clients.

I am actively taking on new corporate clients and welcome direct company inquiries and referrals. My contact information is noted on the right-sidebar, just above the little trophy.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.

What "You May Be Worth Someday" Statements

I recently had to complete an updated net worth statement for my firm’s partnership banker. After completing the statement, my net worth seemed higher than I expected. However, as I reviewed the statement, I realized that this document would be more accurately considered, at least in my case, as a “what you may be worth someday statement".

I say this because if I removed my house from the net worth statement (I intend to live in my house as long as I am physically able) and discounted my partnership interest to account for the multiple variables that could affect that value, either up or down, my net worth statement looked a lot leaner. If I made these adjustments, my net worth statement would reflect how I view my current net worth and provide me a better visual of my retirement building net worth.

This revelation made me smirk. You see, a common complaint I hear from my clients is that they are “worth way more on paper or dead and not worth much in tangible today value”. I smirked a second time when I realized my wife had to sign off on the form. I constantly drive her nuts when I tell her that we have to pay far more attention to our retirement funding and now she was going to see a standard net worth statement that was misleading in my mind.

So why do I consider net worth statements misleading? If you are an employee and you do not own your own business, the statements are misleading because the majority of your net worth is most likely real estate based. Real estate value generally comes in three forms; your principal residence value, cottage value and investment property or vacant land value.

Let’s break down these components. While there is no denying the value of your principal residence, the reality is many people wish to continue living in their principal residence until they are either unable to physically do so, or it becomes a financial requirement to sell or reverse mortgage their home. Thus, I consider a house a net worth backstop and the only value you can currently attribute is the incremental value you would recognize if you were to either downsize your home, sell your home and rent or reverse mortgage your home. In fact, as I reflect further, you probably need another variation of a net worth statement, a "retirement net worth statement" to account for the difference in net worth between your current home and the cost of your downsized home or debt related to any reverse mortgage. 

In regard to investment properties, the value is a fairly hard number; since the property or land is not required for shelter. However, the value of the second property or vacant land can only be maximized if you do not have to liquidate on an urgent basis and you sell when market conditions are strong. Thus, the current value attributed to an investment property could be significantly overstated depending upon the current economic climate and the demand for the investment property; however, it should definitely form part of your net worth statement.

Cottage properties are a bit of a hybrid. Cottages may be similar to a house in that you intend to use your cottage until you are physically unable, or they may be like an investment property, you wish to sell upon retirement. Finally, some people intend to sell their cottages to their children for "hard cash".

If you have a business, your net worth and retirement are often both dependent upon the value you realize for your business. The vagaries of realizing that value are why I consider a net worth statement misleading. If you have a service business such as mine, there is less risk initially in starting the business since if it does not take off, you take your clients and work for another professional firm. However, once the business is established, its value is subject to market conditions such as supply and demand (the accounting profession is top heavy in age), technological advancement of the practice  and its condition when you are ready to sell or, in my firm’s case, transition to the next generation of partners. I have had many a client sell their business sooner rather than later because they were concerned that when they were ready to sell their business, the business or economy may have taken a turn for the worse and they would not realize what they required for retirement. Sometimes these clients have sold at a substantial discount for “a bird in hand”. What I will realize on my share of my firms partnership interest will be determined by such things as the economy, tax laws (say a flat tax is enacted) and our succession plan.

Finally, net worth statements have the same flaw as many retirement plans; they do not account for the impact of income taxes. If I reduced the value of my RRSP by 46% and reduced the value of my partnership interest for the inherent income taxes, again my net worth statement would look significantly different.

So what is the takeaway from this post? First, don’t get mesmerized by a real estate inflated net worth statement. Second, you should probably assume a discounted value for your business, and finally, remember; your future tax liability has not been accounted for on your net worth statement.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.