Canadian couple’s U.S. mortgage payments balloon

Client profile

Renata, 46, and Naveed Kattan*, 44, own a vacation property in the U.S. The Canadian citizens are worried about how they’ll service their outstanding loan now that the loonie has dropped.

*This is a hypothetical scenario. Any resemblance to real persons or circumstances is coincidental.

The expert

David Chalmers

Financial advisor at Nicola Wealth Management

The situation

On their fourth wedding anniversary, in October 2010, Naveed and Renata decided to buy a cheap property south of the border. They paid US$300,000 for a 3-bedroom, 2.5-bathroom home in Fort Lauderdale, Fla., 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 allow friends to use the property rent-free when they’re not there, and don’t otherwise generate rental income.

6

Degree of difficulty

6 out of 10.

6 out of 10. Advisors need to explain the real costs of owning U.S. recreational property before clients buy. This includes what happens if the loonie drops, the impact on estate taxes and how much the property would cost daily. A better option might have been for the couple to stay in a nice hotel whenever they visited Florida. Let clients know that investing, or paying down credit card and mortgage debt, are better ways to allocate excess income.

Since they’re not U.S. citizens, and don’t currently live there long enough to trigger residency status, they don’t have the option to deduct mortgage interest or other costs from their taxes. The couple has no children. Renata earns $85,000 per year as an HR manager; Naveed’s annual salary as a marketing consultant is $78,000. They owe about $8,500 total on credit cards and a personal loan, and have close to $250,000 outstanding on their primary residence—a detached home in Ajax, Ont., currently valued at $420,000.

Both have maxed-out RRSPs after 20 years of steady contributions. Renata’s starting salary was $28,000, increasing $2,850 each year; Naveed’s was $32,000, increasing $2,300 annually. Their RRSPs return an average 5% annually; Renata’s balance is $308,135, while Naveed’s is $306,021. Each of them also has a maxed-out TFSA, at $41,000 and $44,000 after returns. They’re both in a conventional mix of global and Canadian mutual funds, with a 30% fixed income component.

The solution

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.”

If they’d done their due diligence, they wouldn’t be so worried, thinking, “What’s going to happen now that the dollar has dropped?” In their current situation, he adds, they have three options: continue servicing the loan, rent 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.

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.”

Selling

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 get rid of the burden on their household cash flow. “So they should sell the property, take the profit and pay off the mortgage on their own home.”

Client acceptance

8/10

Renata and Naveed don’t want the hassle of renting the property and it defeats their initial purpose—having it available for their personal use. A similar property down the block sold for US$515,000, so they list theirs for the same price and sell it at asking. After paying the tax on the $215,000 capital gain, as well as selling costs, they make a profit of US$150,000, or C$187,500 at the current exchange rate. They use the money to pay down their mortgage.

Suzanne Yar Khan is a Toronto-based financial writer.