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A hard-working entrepreneur who runs a restaurant and retail outlet, Jim hopes to retire while he is still relatively young and live off the income from his rental properties.
Jim and his partner Bethany live with their toddler in her home in small-town Alberta. He is 43, she is 38. Jim also has a 12-year-old child from a previous marriage.
Jim's short-term goals include buying four more houses – the ones he has are in Alberta and British Columbia – paying off his mortgage debt and perhaps forming a holding company if it makes sense. Longer term, he wants to retire comfortably at age 50 and leave something for his children.
Jim is doing well, bringing in $10,000 a month before tax from his businesses. He estimates his share – he has partners – is worth $750,000. Bethany, who keeps her personal finances separate but contributes to joint food and housing costs, earns $75,000 a year before tax.
On paper, Jim is looking good. He has $3-million worth of investment real estate. Still, he is mindful of the other side of the balance sheet – the $1-million-plus of mortgage debt, which he hopes to have paid off by the time he is 55 or 60.
"I could maybe use a facelift," he writes in an e-mail.
We asked Jillian Bryan, a portfolio manager and investment adviser at TD Waterhouse in Vancouver, to look at Jim's situation.
What the expert says
Setting up a holding company offers a number of advantages, Ms. Bryan says. After-tax profits in the operating company can be distributed to the holding company as tax-free dividends.
"If he doesn't need all the salary as time goes by, he can keep money in the holding company and avoid paying personal tax," she says. As well, if too much profit is retained in the operating company, and this money is invested rather than plowed back into the business, the operating company could lose its small-business status and hence its preferential tax rate. Ninety per cent of the operating company's assets must be used to earn income in the business.
Another advantage is that funds in the holding company are protected from the operating company's creditors, and income from investments made by the holding company is not subject to personal income tax, Ms. Bryan says. Having a holding company also presents opportunities for income-splitting with a spouse and estate planning opportunities .
As for the mortgage debt, Jim should strive to pay off as much of it as possible before he retires. While the mortgage interest is tax deductible, paying the debt sooner "will allow him to free up and enjoy more of his rental income," she says.
So can Jim retire at age 50?
Jim figures he will have his mortgage debt paid off by the time he is 55 or 60. His financial picture at age 50 is less clear. As well, Jim doesn't have a firm handle on how much money he will need when he retires. In his application, he lists "spending money" of $2,500 a month or $30,000 a year after tax.
Ms. Bryan trains her eye on the two children and the cost of educating them. Then there are the other revenue properties Jim plans to buy to lift his total to 10. "Although he has lots of real estate, his rental income is only generating $1,000 a month net of expenses," she notes. If Jim retires, he will no longer be taking home $7,000 net from his two businesses.
Clearly, Jim needs to do some preretirement planning.
He could start by drawing up a schedule of mortgage amortizations for his rental properties showing "the amount and timing of cash-free income," Ms. Bryan says. "This is critically important because the revenue property income will be supplementing his investment portfolio income if he sells his businesses." The schedule will help Jim determine whether he should add to his holdings or do some judicious pruning.
Jim is taking home $84,000 a year from his businesses now plus another $12,000 in net rental income, for a total of $96,000. If he sells his share of the businesses for $750,000 and invests the proceeds at 4 per cent a year, he will be making $30,000 a year before tax. When calculating how much Jim might need in retirement, the adviser uses a rule of thumb of 70 per cent of preretirement earnings, which in Jim's case would be $67,200 before tax. Thus his revenue properties would have to generate at least $37,200 a year after operating expenses to make up the difference, substantially more than the $12,000 a year they are throwing off now.
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Client Situation
The people
Jim, 43, and his family.
The problem
Can Jim afford to retire from his business in seven years and live off the income from his rental properties? Should he form a holding company for his assets?
The plan
Draw up financials for the rental properties showing when the mortgages on each will be repaid in full and how much cash they will generate. Plan accordingly. Review the situation closer to the target retirement date before making a final decision.
The payoff
A road map that will substitute hard numbers for hopes and ambitions.
Monthly net income
$8,000
Assets
Bank accounts $25,000; stocks $50,000; TFSA $25,000; RRSP $25,000; RESP $10,000; six rental houses $3-million. Total: $3,135,000
Monthly disbursements
Mortgage $900 (his share of $1,800); other housing costs $790; car lease $500; other vehicle costs $390; groceries $250 (his share of $500); child care $900; clothing $300; gifts, charitable, other $150; vacations, travel $200; dining out, entertainment $250; clubs, sports $150; grooming $50; doctors, dentists $250; drugstore $100; cellphone, Internet $200; RESP $200; TFSA $400. Total: $5,980
Liabilities
Mortgages $1,062,000; car loan $17,000. Total: $1,079,000
Special to The Globe and Mail. Want a free financial facelift? E-mail finfacelift@gmail.com. Some details may be changed to protect the privacy of the persons profiled.