A couple of weeks ago, Financial Post released an article that says Scotiabank sees eight Bank of Canada interest rate hikes by end of 2023.
8 interest rate hikes! Yikes!
As a real estate investor myself, I couldn’t help but wonder – is this a good time to lock in the low rates by converting my variable interest rate mortgage to a fixed one?
I had converted variable rate mortgage to fixed-rate mortgage when my variable rate “discount” was high.
The truth is, I’ve found myself paying for tens of thousands of penalties every time I committed to a fixed-rate mortgage.
It turns out that I changed my plans more often than I had intended and I incurred tens of thousands of dollars of penalties.
Here’re the top decision factors as to whether you should convert your variable rate mortgage to a fixed-rate mortgage.
I consulted with my mortgage broker Kevin and found that the 5-year variable rate offered by one of the big banks is at 1.60% and upwards and 5 year fixed rate is 2.69%.
In my mind, I would have opted for a variable rate in a heartbeat. 😊
If you borrow $800K from the bank with 30-year amortization, going variable can save you $437 on a monthly basis.
That’s a lot of money!
But if you were to refinance a property, the situation can be more complicated.
When you refinance to get a bigger mortgage, the bank may only offer you a fixed-rate mortgage (that was the case with me when I moved my mortgages to a different bank). I was able to qualify for a bigger amount with a fixed-rate mortgage, as compared to the variable-rate mortgage.
On the other hand, if you were to simply convert an existing variable rate mortgage to a fixed rate mortgage worrying that the Bank of Canada will raise the rate 8x in the next few years, a detailed comparison should be conducted to see whether it makes sense to do so or not.
In early 2020, I converted all of my variable mortgage to a fixed mortgage with the same bank.
No penalty was triggered.
At the end of 2020, I decided to move three of these mortgages to my corporation with a different bank to free up some of my personal credit to qualify for a bigger mortgage in my personal name.
Of course, breaking a mortgage from one bank and refinance it with a different bank triggers a mortgage penalty.
We paid tens of thousands of dollars to break free and buy back our credit.
Lessons learned: if you are planning to refinance the property or sell your property soon, don’t go fixed.
If you still want to go for fixed, try committing to only one year or two year term fixed rate mortgage, instead of five year term fixed mortgage.
The mortgage penalty on a fixed-rate mortgage is calculated based on the greater of interest rate differential or three months interest. Typically penalty calculated based on the interest rate differential on the outstanding balance with the remaining term is significantly higher that of three months interest.
Mortgage penalty on a variable rate mortgage is calculated based on the 3 months’ interest outstanding.
As you can see, the cost of breaking a fixed-rate mortgage can be a lot more expensive.
If you plan to sell or refinance the mortgage in the near future, a fixed rate is less preferred.
If you are breaking a higher fixed-rate mortgage to convert to a lower variable rate mortgage, you may want to consider the cost of the mortgage penalty.
If you are breaking a mortgage for the purpose of investment, chances are, the mortgage penalty incurred is tax deductible.
If you are breaking a mortgage of a rental property to pay off your personal mortgage, the deductibility of the mortgage penalty can be trickier.
Depending on your particular situation, if the mortgage penalty can be deductible as an expense, the penalty is then less expensive than the mortgage penalty that isn’t tax-deductible.
Be sure to consult with a real estate accountant that knows these rules well before making a decision.
Just because you can write it off, does not mean that there’s no after tax cost.
If I were to borrow $800K from the bank to purchase a rental property, I would opt for a variable rate.
Variable-rate at 1.60% means that my monthly payment amount = $2,797.46
Fixed-rate at 2.69% means that my monthly payment = $3,234.26
For those investors who want peace of mind that their monthly payment won’t go up in the next few years, here’s what I would do…
Sign up for a variable rate, but increase your monthly mortgage payment amount to the fixed amount.
Using the example above, the bank requires me to pay $2,797.46 if I go variable.
I would instruct the bank to make a payment of $3,234.26 instead – so I am already used to paying a higher amount.
The extra $437 payment that I make goes straight to pay down my outstanding mortgage on a monthly basis.
At the end of one year, my mortgage outstanding amount is lowered by $5,306 as compared to opting in for the fixed mortgage.
My cash outflow is exactly the same, but the extra goes straight to my mortgage principal paydown, which also carries a compound effect on my monthly mortgage payment.
By the end of the second year assuming there is no rate increase, my mortgage outstanding is lowered by $10,757 cumulatively.
If you are concerned, go for variable, but pay as if you’re committed to fixed-rate mortgage.
Not everyone can qualify under for variable rate mortgage. I was a good example back in 2020.
If I ever have to break a mortgage, regardless of fixed-rate or variable rate, I always try to make a mortgage prepayment so that I can minimize the mortgage penalty I would otherwise owe.
As mentioned above, the mortgage penalty on a fixed-rate mortgage is calculated based on the greater of interest rate differential or three months interest. Typically penalty calculated based on the interest rate differential on the outstanding balance with the remaining term is significantly higher than that of three months interest.
The mortgage penalty on a variable rate mortgage is calculated based on the 3 months’ interest outstanding.
Mortgage penalties are calculated based on the amount outstanding. The more you can pay it off, even if it means using your home equity line of credit short-term, the less penalty you will incur.
Enough talk about rates, hopefully, the Bank of Canada won’t raise our rates 8x in the next two years.
Until next time, happy Canadian Real Estate Investing.
Cherry Chan, CPA, CA
Erwin and I met each other 10 years ago.
At the time when I met him, I was the classic middle-class example described in the book Rich Dad Poor Dad. I lived paycheck by paycheck, I spent all my money on a nice Mercedes and living in a 3+1 executive townhouse in Toronto by myself.
I was basically chained to my job. I couldn’t leave it because I needed the money to support my lifestyle.
I met Erwin and he introduced me to the world of real estate investing outside of Toronto.
I learned that I could refinance my Toronto townhouse and use the funds from refinancing to invest.
Erwin convinced me to use the funds to invest with him.
We found a student rental located in St Catharines targeting Brock University students. He s the property. I ran the numbers. We put in an offer in my name only. It got accepted!
Back then, offers were accepted with condition. He arranged and attended the home inspection.
I didn’t get to see the property until after it was closed.
I put in the down payment and renovation money. He put in the time and effort.
The idea is that I would be the money partner and he would be the sweat equity partner.
We would split the profit 50/50 when we sell.
That’s how we formed my very first joint venture partnership 10 years ago.
At the time, we were still dating. I was never exposed to this idea of forming a joint venture partnership. We didn’t sign any agreement.
The only thing I thought to myself was…even if our relationship didn’t work out, at least the property is in my name. If we were to break up, I didn’t have to pay him anything. 🤣😂
Thankfully, we didn’t have to go through any ugly break up process.
Looking back, the decision to not draft up an agreement was not a smart one. In fact, after working with so many real estate investors and their respective joint venture partners, I came to realize the importance of an agreement and the details involved.
Here are the top 5 elements you shouldn’t miss when you invest with someone.
When you invest with someone, it is extremely important to sign an agreement.
Sometimes, you might invest in a property by forming a joint venture relationship, similar to the one Erwin and I have.
Sometimes, you might invest with someone through a corporation. Both you and your partner own shares of the holding corporation.
In some other cases, you might invest through a limited partnership structure.
Regardless of the investment vehicle, you should always sign an agreement to detail all the essential terms below.
In the case of a joint venture partnership, a joint venture agreement should be signed.
In the case of a corporation, a shareholder agreement should be signed
In the case of a limited partnership investment, a limited partnership agreement should be signed.
A budget and a plan of action is often created when the investment opportunity presents itself.
When I invested in the student rental with Erwin 10 years ago, I knew that I would be responsible for the down payment, the closing cost including land transfer tax and legal cost, and the initial upfront cost to renovate the property for our investment purpose.
The initial understanding is important, but it is even more important if you put everything on paper so both parties have a mutual understanding of who’s responsible for the down payment.
Real estate investments aren’t always sunshine and roses.
Tenants might not pay for two weeks. Sometimes tenants don’t pay for months.
Water leaks from second floor to the kitchen, which just happened to us in one of our properties.
Who’s going to pay for the repair when the shared bank accounts do not have any cash for it?
It’s much easier to spell out who’s responsible at the very beginning…just in case.
Even though we often refer to rental income as passive income, the reality is that it isn’t as passive as it seems.
It’s important to spell out who’s responsible to do what in the agreement. This can include but not be limited to the following:
Ultimately, the reason why we choose to invest together is to generate return on investment.
The agreements need to spell out how you split the money in the following scenario:
Depending on how you and your partners split the money, it poses different tax implication to different partners.
Business relationships are like marriages. We don’t always agree with our spouses.
It’s much easier to setup some ground rules at the beginning to decide how you want to resolve the conflict if they ever arise.
You might never have to use those ground rules to resolve any issues.
Do you have an exit plan when you invest with an investment partner?
I didn’t have an exit plan at the time when I formed this joint venture relationship with Erwin. In the back of my mind, in case of a relationship breakdown, I would just take the house that I’m on title and run. 😉
It worked out, but it isn’t right. Don’t do what I did.
The older I am, the more I come to appreciate the importance of a plan. Exit strategy is part of that plan.
If you want to hold the property for five years, whereas your partner plans to hold it for 10 years, you may have a mismatch in terms of expectation.
It’s always nice to plan ahead with exit strategy, communicate the expectation and you can always renegotiate over time.
Imagine, you and your friend decide to invest in a rental property together. Since you guys are good friends and have a great understanding in terms of investment objectives, you don’t feel that there’s a need to set up an agreement.
Unfortunately, something happened to your friend, and he passed away unexpectedly.
Now, if his name is on title and you’re the sweat equity partner… how would you be able to access the bank accounts and financial information? Who’s going to pay for mortgages?
What if his wife, who inherited the property, doesn’t know about your arrangement with your friend and refuses to recognize your contribution?
To protect both parties, it’s always important to spell out the next steps just in case the unfortunate event happens. You may never use it, but it is there just in case.
I’m not a lawyer. These are the bare minimum that you should include in your agreement with your investment partner.
Make sure you consult with a real estate lawyer who’s familiar with joint venture agreements to set one up for you that’s suitable for your need.
Until next time, happy Canadian Real Estate Investing.
Cherry Chan, CPA, CA
Your Real Estate Accountant
A handful of my self-employed clients recently reached out to ask us about Health Spending Accounts (HSAs).
HSAs are essentially self-insured health plans that allow employers to provide health care benefits to employees’ tax free.
Employers get to deduct the expenses and employees get to enjoy the benefits tax free.
If used properly, real estate agents and real estate investors can write off their medical expenses against their business income, which can provide significant tax benefits.
What is a Health Spending Account?
Health Spending Accounts (HSAs) are essentially self-insured health plans arranged by employers for employees in Canada.
Back in the days when I was working as an employee for Deloitte, we used to have HSAs as part of the benefit package.
Each employee is allocated a fixed amount of spending. Employees get to choose what they use the money for, can be massage, dentist, optometrist, etc.
This allows the employers to deduct the money they spend on funding the HSAs. Employees get to receive the benefits tax free.
What type of Health Spending Accounts is deductible in the eyes of CRA?
Not all HSAs are born equal. Some are tax deductible and some aren’t. To qualify for a tax deduction as per CRA, all of the following conditions must be met:
In addition to it, only certain HSAs are acceptable:
Sole proprietorship with no arm’s length employees CANNOTdeduct money used to fund HSA as private health services plan against his/her business income.
How does Health Spending Accounts work?
When employees incur medical expenses, they first pay for it using their own fund.
They then mail the receipt and support to the Health Spending Accounts administrator.
Employers send the same amount of money to the Administrator.
Administrators issue a cheque to reimburse the employees.
Money sent by the employers to the HSAs Administrators are tax deductible against revenue, provided the plan and employers both qualify the criteria mentioned above.
Employees receive the medical benefits tax-free.
How does it benefit real estate agents and real estate investors?
When my family and I incur medical expenses, we pay for them ourselves out of pocket. We have our own businesses, and we did not have medical plans coverage before.
We keep the receipts. At the end of the year, we would tally them all up, enter them into our personal tax returns.
If your medical expenses qualify for medical expense tax credit and the total amount incurred is greater than 3% of your earned income or up to a maximum of $2,397 in 2020, you get to claim the excess as a tax credit.
Let me use an example to explain.
Say you earned $100,000 of net income; you want to see how much you can claim as medical expense tax credit…
CRA takes your net income $100,000, multiply that by 3% = $3,000, which is greater than the threshold of $2,397.
This means that you need to incur MORE than $2,397 medical expenses BEFORE you get any tax credit benefit from the medical expenses.
If you only incur $500 medical expense, your claim will not give you any benefit.
If you incur $3,000 medical expense during the year, only the EXCESS amount $3,000 – $2,397 = $603, is used to calculate the tax credit.
And this $603 does not come off your income as a tax deduction. It is claimed as a personal tax credit.
You get $603 x 20% (basic combined tax rate in Ontario) = $121 tax credit against your personal tax.
However, if you incur the medical expenses via a Health Spending Accounts and assume that your HSA qualifies as a deduction with CRA…
If you operate as a sole proprietor and you have an arm’s length employee, you can claim this $3,000 as a tax deduction. If you net $100,000, you can offset the $3,000 against the $100,000 net income and now you save $3,000 x 43% = $1,290.
$1,290 is a lot better than $121!
If you are an incorporated real estate agent, as long as you are working as an employee receiving salary, with the use of Health Spending Accounts with a proper administrator, you can deduct the medial expenses against the business income reported in the corporation, essentially having your corporation paying for all medical expenses incurred.
The amount of taxes you can save when you’re an incorporated employees can vary, depending on the amount of remuneration you draw out from the corporation.
Bottom line
Health Spending Accounts can provide tax benefits if HSAs are setup in accordance with the CRA guideline.
Make sure you speak to your accountant to see if this is right for you.
Until next time, happy Canadian Real Estate Investing.
Cherry Chan, CPA, CA
Your Real Estate Accountant
P.S. For the record, my businesses already have a benefit plan setup. Our plan is NOT a HSAs so I do not have personal experience with any HSAs provider.
P.P.S. I’m going to host my next incorporation webinar on Nov 16 at 8pm. If you want to find out more about incorporation, please register here.
A friend of mine entered a private lending deal in 2019.
For those of you who don’t know much about private lending, basically, we get to be the bank and lend money to others and charge interest in return.
There are a few advantages of private lending:
But…where’s the catch?
Like every other investment out there, the investors need to do their own due diligence on each deal.
Here are some potential risks that one should consider:
Back to my friend’s deal…
In 2019, she lent $60K private money, secured as a second mortgage on a single-family home in St. Catharines. Interest rate was 14%.
The appraised value of the property at the time was $250,000.
First mortgage was roughly $152,500. Her loan is registered as the second mortgage behind the first mortgagee.
For those of you who don’t understand what this means, in the event of a foreclosure or power of sale, the property is forced to sell in the open market to repay the debt outstanding. The first mortgagee would be repaid FIRST before her second mortgage.
Together with her $60K loan, the total loan to value registered on the property was 85%.
My friend thought that 85% loan to value provided enough buffer to protect her second mortgage. After all, the cost to sell a property would normally be 5% realtor commission and lawyer closing cost.
The borrower worked as an office clerk.
He defaulted 6 months into the term on the second mortgage. He defaulted the payment on the first mortgage a couple months before that.
The first mortgagee forced power of sale and my friend got notified as her loan was registered against the property.
To save the deal, she bought the property for $255,000.
In her mind, she was using her $60,000 second mortgage as the down payment for the property. She got a brand new mortgage in her name for $200,000.
Total consideration paid by her was $260,000, which was more than enough to cover the purchase price of $255,000.
At closing, the lawyer called her and told her that they wouldn’t be able to close.
The first mortgagee was owed another $30,000 interest and fees incurred from the default.
The deal couldn’t close unless she put in this extra $30K.
The first mortgagee lent $152,500, got $230,000 back from the sale of the property.
Essentially the first mortgagee charged $77,500 in fees, interest, and penalties. ☹
Crazy!
She paid. She closed the property.
She put in another $50K to freshen it up and rented it out for a couple of years.
Earlier this year, she sold the property for $500K.
She made more than double of her initial investment back in 2 years.
What are the lessons learned?
You may wonder – can she write off the $30,000 that she put in extra to close the deal? Absolutely. It is added to the cost of the building, and she can deduct it against the sale price.
Until next time, happy Canadian Real Estate Investing.
Cherry Chan, CPA, CA
Your Real Estate Accountant
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