Big dreams, low risk appetite

Cross-jurisdictional taxes, small-business issues, and complex estate planning all came up in this year’s IAFP case study, which looked at planning challenges faced by a real-life, entrepreneurial couple that had moved from Australia to Canada.

Vancouver-based BC Partners in Planning (BCPIP) presented the case on day one, September 13, of IAFP’s conference. It looks at Josie, 41, and Damien, 40, who want to retire at age 55 and buy a home in Quebec. Like most investors, they’re extremely concerned about how their finances would be affected by the recession.

The case

Employment history:

The couple operates a textile importing business that produces approximately $200,000 a year in taxable income through sale of goods and collection of commissions. However, the firm’s status as a proprietorship makes them responsible for all losses and debt.

Family:

They have a toddler, and a baby on the way. The children are too young to predict if they’ll want to inherit the company.

Insurance:

Each holds a T20 $500,000 life insurance policy, but only Josie has private disability coverage.

Investments:

Both have heard portfolio diversification is essential, but are unsure of whether they should move beyond simple stocks and bonds. Damien has a self-managed portfolio in Australia, and Josie holds various investments worth about $400,000. She’s also a joint beneficiary (with her siblings) of a $3.8-million family trust.

Real estate:

Josie owns three properties in Vancouver, one of which is their primary residence. Plans are to sell the residence and keep the other two rentals. The couple also owns a home in Tasmania, which they’re not renting out.

Estate planning:

Neither has completed a will; especially egregious since their net worth exceeds $2 million and they have a growing family.

Their goals

Their main objectives are to buy a home in Quebec close to Josie’s family, and retire at age 55 on $60,000 per year. They also want to start a farm on that home’s property. They’d already started researching homes, and needed help with the purchasing process.

Their retirement goals are aggressive, given the majority of Canadians are both living and working longer and their 15-year horizon.

Damien, who has a degree in agronomy, wants to start a farm on the new property, and plans to fund the venture by liquidating his investment portfolio. The operation will grow grain, so he needs more than 600 acres.

The issues

Debt:

BCPIP’s Marian Snowball says one big problem for the couple is that all three properties are mortgaged. Also, property isn’t liquid. Since their cash flow is already limited, they face further risk.

She adds, “There’s also a practical issue with renting several properties when you have small children. Neither Josie nor Damien are extremely experienced managers and face possible trouble with managing the properties when also responsible for the farm and a young family.”

Estate:

The couple needs to create one, but it can’t be done immediately due to their plans to move to Quebec. (They’ll need to reside in-province before drawing up a will there.)

Citizenship:

Josie is Canadian, but Damien isn’t. He was, however, already a resident, so this didn’t complicate asset ownership. It simply meant their taxes were more complicated since he had income and gains to report from Australia, which has a June 30 year-end.

So what actually happened?

The team started with the simple stuff. The mortgage debt from their rental properties, approximately $600,000, was all tax-deductible, says BCPIP’s Ken Snowball, since they used them as income-producing assets. Damien also visits B.C. a few times a year to do maintenance on the properties.

When it came to the couple’s investments and retirement goals, the team advised them to remain conservative. BCPIP’s team recommended a mix of 50% stocks and 15% bonds, along with 30% in real estate and 5% in cash for liquidity.

The same was true of their current insurance coverage. Purchasing the farm would change their insurance needs, but for the time being they were covered.

Since the couple mainly owns real estate assets, as well as a business, the advisory team urged them to look at trusts.

“Putting property in trusts reduces the bequests requiring a will and also reduces the risks [that come with] beneficiaries actually owning the property. Of their total $2.5 million, a large portion of their wealth would end up protected in a trust. This would also leave only a small portion of their wealth vulnerable while a will was being created to cover the rest of their concerns,” says Ken Snowball.

He adds creating a trust is also crucial “for those who have an operating company, and who want their kids to share in dividend income once they’re of age. Without a trust, the kids will have direct ownership in the company and it will be subject to family division rules. With a trust, the beneficiary has no legal right to the underlying asset, and neither do their spouses.”

Josie and Damien put their business into the trust and then created a holding company for the two rental properties.

That way, the assets will be taxed within the trust, not in their hands, and their children won’t have to pay probate because the assets won’t be in the will.

The home in Quebec

Ken says it was essential to help the couple purchase their home, so they could get on with their plans to become farmers. First, they did a debt swap to finance the Quebec home purchase—their new primary residence—and to make that mortgage tax-deductible.

Josie and Damien needed $920,000 to buy the property in Quebec, so they borrowed $300,000 against one of Josie’s rental properties to pay off the mortgage on their former primary residence in Vancouver. Then, they sold that residence for $570,000.

They originally planned to sell their non-registered assets and Damien’s Australian assets for approximately $350,000 to make up the shortfall. But Damien didn’t want to trigger Australian capital gains taxes, and wanted to use those assets to fund the farm’s setup.

So, the team found an alternative. Through her family trust, Josie is allocated at least $60,000 of dividend income per year. That money stays invested as shareholder’s equity within a company owned by that family trust.

Marian Snowball says, “Because Josie owns this pool, she was legally free to take it out.” So she took out $350,000 from the company in the family trust and bought the Quebec house.

Then, she took out a loan against that same house to pay back the $350,000 she took from the investment company related to the family trust. By doing so, she gained a tax deduction on the money she invested back into the investment company.

Marian says the main benefit of doing this debt swap is to make sure the debt is pointing toward an income-producing asset in order to gain this tax deductibility.

Besides helping with the home purchase, the team also tracked the couple’s expenses and portfolio performance during and after. They deemed they were on track to accumulate their desired retirement funds within the next 15 years.

They’ve now set up the farm and have made great headway with the land despite some extreme weather conditions. Liquidation of Damien’s Australian investments paid for farm equipment, as well as the removal of fences, building grain silos and installing underground wiring.

The farm couldn’t be owned by the same holding company that owns the two rental properties, because Quebec law requires Damien and Josie to have controlling interest in the farm. So, it went into a third company (see “The trust structure,” this page).

Damien believes the land was undervalued, so expects they will see significant gains if it were sold. They also purchased further insurance to protect their crops and land.

To date, the two are still clients. They’re actively tweaking their portfolio based on the success of their farming business and the needs of their family.

The trust structure

Katie Keir is assistant editor of Advisor Group.