Colin S. Ritchie

Apr 10

Making the Right Call: The Ins and Outs & Ups and Down of Covered Call Funds

As I’ve said many times before, few things in the investment world make me happier than receiving nice fat deposits into my investment accounts on a regular basis. I may have never been to Mississippi, but I strongly suspect that I’d have a strong affinity to the Show Me State.

I get even more excited when I know that I won’t have to share too large a portion of those juicy payments with the government come tax time. As I have been known to repeat ad nauseum, it’s not what you make, but what you keep after fees and taxes that really matters. Inside registered accounts, all distributions are treated the same. Accordingly, it’s irrelevant how you make your money in such accounts, so long as it’s an appropriate investment for your temperament and circumstances. On the other hand, how you get paid inside a non-registered account, whether in your personal or a corporate account can matter a heck of a lot. That’s where covered call mutual funds or etfs (I’ll use “funds” to describe both hereafter) might really shine.

Background

Put in simplest terms, a fund that “writes” or sells covered calls trades some of the potential upside from the stocks they are selling call options on in exchange for an upfront payment called an “option premium.” Using an example, if you own a stock worth $100, you might sell someone the right or option to purchase that same stock from you for $103 any time over the next month in exchange for an extra $.50 right now. If the stock never hits this value, the option will expire as worthless and the person purchasing the call will be out $.50 with nothing to show for it. You, on the other hand, will get to keep the stock, any dividend income paid on it, plus the up-front $.50 option premium payment. And, if you’re so inclined, you can start from scratch and sell another call option the next month.

Conversely, if the stock soars to $105 prior to the option expiring, you will be required to sell at $103 (or buy back the option) and miss out on that extra $2 of profit. So, although you are stuck selling a stock worth $105 for $2 less than market value, you still realized a $3 on the increase of value, any dividends issued, plus the $.50 option premium. Accordingly, although you didn’t do as well as if you hadn’t sold a call option or the person who purchased it who and made a 300% profit, you still have a lot to smile about. And, if you’d been collecting options premiums on that same stock for several months before it was “called away,” (forced to sell your stock at the price stipulated or “strike price”), you still might still be ahead of the game compared to simply buying and holding that stock.

Finally, if the stock goes down over the call period, although you’re probably not too happy about this, at least you’re $.50 better off from receiving the call premium than the guy down the street that owed the same stock but didn’t write a call. And, if you were a retiree on tight budget, the extra $.50 in call premium per share may mean not having to sell as many shares during a setback to pay for groceries. In summary, covered call funds usually underperform typical funds in a rising stock market but the higher income they generate vs. owing a similar basket of individual shares might be very attractive to more risk-adverse or income-hungry investors more interested in monthly payments than growth.

Option Pricing Basics

In the example I provided, I arbitrarily pulled numbers out of the air in order to explain the general concept. The value of any call option is highly variable and is affected by the following:

The prospects and volatility of the underlying stock: A stock that goes up and down like gymnast on speed generates a higher premium than a staid blue chip special, as the upside if the riskier stock catches fire during the option period is that much higher and, thus, enticing.

General Market Volatility: As you might expect, not only does a specific stock’s volatility affect what you can charge for an option premium, but so does that of the stock market as a whole. For example, options premiums will be a lot higher during an event like a global pandemic than when all is sunbeams and moonshine.

The Length of the Option Period: If you write an option that lasts 3 months, you should be entitled to a higher option premium than writing one that lasts a single month, since whoever purchases the option has three times as long to strike it rich and for a hot stock to keep on climbing.

The Difference Between Strike Price and the Stock’s Current Value. In my example, the “strike price” of the option was $103 for a stock currently trading at $100. If the strike price was only $102, the option premium will be higher since there is that much better price of the option eventually “being in the money” and rewarding the buyer. Likewise, as you’re agreeing to surrender more of the upside if pricing the strike price close to the current value, it only makes sense if you’re paid more in exchange. Finally, the increase in the option premium as the difference between the strike price and market price decreases can increase significantly as buyer risk goes down and seller opportunity cost rises. Accordingly, if the seller in my original example was selling a call option for $101 or even one that is already “in the money” such as a $100 call option, they should expect to get significantly more than the $.50 option premium from my example.

Advanced Lessons

As you might expect, things are not quite as simple as the example I’ve described above when looking at this strategy inside a fund versus on a single stock basis. Different companies have different strategies, so it’s important to understand how the various funds differ from each other before deciding on what does (or doesn’t work) best for you. Here are a few of the things to consider:

Do you believe in that market sector? In basic terms, if you don’t like the sector, don’t chase the income stream on the related covered call funds, or at least limit your exposure. And, even if you like the sector, beware of too much of a good thing in case your hunch doesn’t pan out. Consider a basket of different covered calls funds with different holdings or look into funds that do this for you rather than merely buying sector specific funds.

On what percentage of the fund are they writing calls? Most covered call funds don’t write calls on the entire fund. Accordingly, the more shares that aren’t optioned, the more potential upside in a rising market vs. a fund that has written calls on a higher percentage of its holdings. When comparing funds, take this into account rather than merely focusing on yield. The higher portion of a fund’s shares that aren’t optioned, the better the upside in a rising market.

What is the maximum percentage of a fund that can be optioned? Many funds target a set yield and will write just enough options each month so that the combined dividend and covered call premium yield generates the desired yield. Accordingly, in more volatile times, a fund may not need to write as many call options to hit their yield targets if each call option pays a higher option premium than during a quieter market. That said, funds may also restrict the maximum percentage of shares optioned at any one time. One way or the other, it’s good to know both what’s going on right now and the limits on how much can ultimately be optioned away if circumstances change.

What is the fund’s typical spread between the market value of the shares optioned and the strike price of the options and how variable is this? As explained earlier, the tighter the spread, the higher the option premium. In fact, some funds have recently started selling call options that are “in the money” or where price for exercising the option equals the market value of the share. I’ve seen funds like this generate income of the mid-teens but it’s important to remember that you will be giving up the entire upside on all optioned shares in that scenario, which may sting in a rising market. Conversely, when the market hits the skids, these funds should outperform similar options-free funds. Returning to the previous bullet, it’s also vital to know what percentage of the underlying stocks are optioned, as the non-optioned portion of the fund can still appreciate during a rising market. Accordingly, unless the market has gone gangbusters, to use a technical term, such funds may still hold their own when the market enjoys modest but not monumental gains.

Do the funds use leverage? There are several covered call funds out that borrow to purchase perhaps 25% more of the underlying shares, using the extra dividend yield from the extra shares and covered call premiums to cover the borrowing costs. This might allow the funds to more fully participate in rising markets if it means less of the underlying shares are optioned but are more likely to take it on the chin when the market falls. I would also expect that as interest rates decrease and the fund’s borrowing costs decline that such funds would not need to write as many options to generate the target distribution, further increasing their performance against their covered call peers in a rising market.

How long has the fund been around and what’s its track record? The new breed of covered call funds that issue “in the money” options has captured a lot of interest but it’s really hard to gauge their performance against both other covered call funds that employ less aggressive option writing strategies and against more traditional funds that don’t employ options at all. The high yield is amazing and may be answer enough for some, but it’s hard to make an accurate basis of comparison without the necessary historical data. The study I discuss later in this article raises some concerns regarding traditional covered calls. Although a juicy yield is a wonderful thing, keep an eye on the fund’s overall performance. Even better, look at its long term track record if one exists.

Fees! What does any fund charge compared to its peers?

How is the fund’s target distribution typically taxed? In a non-registered account, the distribution from a covered call fund is likely a mix of things. The options premium portion is taxed as capital gains. Depending on the underlying assets in the funds, some of the income may also be eligible dividends, interest income, foreign income or tax-deferred return of capital. Although interest income is usually the least desirable, a lot depends on your tax bracket, as eligible dividends may be disastrous for investors relying on the GIS, nirvana for those with slightly higher tax brackets and not nearly as good as capital gains for investors making the really big bucks. While an investment’s raw yield usually grabs the headlines, knowing what you’ll ultimately get to keep after taxes can help you make a more informed choice. That said, it’s a dangerous thing to make investment choices solely by focusing on taxation.

Additional Thoughts and Arguments Against

There are concerns in some quarters that the chase for option income can actually reduce total returns, such as identified in Larry Swedroe of Alpha Architect’s November 24, 2023 article (A big thanks to Moneysaver reader Dave Reid for sending this along!) That article compares the performance of some covered call funds vs. similar funds that don’t use this strategy and cited another study that concluded that over the study period (1999-2023) that a Nasdaq-focused covered call etf didn’t do nearly as well as a standard, cheaper etf tracking the same index. It also pointed out that a standard etf may be more tax efficient since more of its return translates to deferred capital gains. Finally, it also concluded that the smaller the spread between the option strike price and the stock’s trading price at issue, the worse the fund’s overall performance. In other words, the income from the call options didn’t fully compensate investors for surrendering upside.

This article raises many good points, although I would have loved to have seen a Canadian-based example. In an example where the underlying Nasdaq stocks averaged over 16% annual growth, it is no surprise that the covered call version drastically underperformed.

In defense of covered calls, I think that merely focusing on the total return can also lead to “sequence of return problems” for investors dependent on their portfolios to pay for their daily bread. As I’ve written about previously when discussing the “sequence of returns,” or when an investment has its good vs. bad years rather than its overall performance, having to liquidate stocks during a correction to pay the internet bill can have a disastrous impact a portfolio’s long-term performance, as it forces investors to “sell low.” Such investors may not have the luxury to wait until the stock market cooperates and might instead appreciate a higher income along the way, particularly if they don’t need to shoot the lights out to stay on track for their ideal retirement.

Conclusion

Ultimately, like in so many areas of life, there are pros and cons to every decision. Although wealthier clients with a long time horizon, higher risk appetite and no need to generate extra income may do better with more traditional funds, more income-dependent or conservative investors may look at their investment options very differently. And, if you are one of them and are considering covered calls to help ensure that you have enough to fund your monthly premium peanut butter habit or to sleep soundly at night, I hope this article has helped in your investigation.

Dec 11

Taking Note of the Possibilities: Auto-Callable Contingent Income Notes

I have a confession to make – I’m fussy about surprises. I’d much rather save them for birthdays and major holidays than when reviewing my investments. Admittedly, volatility can sometimes be an investor’s best friend, such as when that a penny stock is suddenly worth dollars, these happy surprises are outweighed by the times things go the other way, which leaves me feeling like I’ve just found out that Christmas was cancelled while sitting on a piece of birthday cake. And, for investors who are on track for a comfortable retirement, are tired of getting motion sickness when tracking the ups and downs of their stock portfolio or are already in retirement and can’t afford to get it wrong, you should feel the same way.

I’ve previously written about how volatility when you have your good vs. bad investment years (your “sequence of returns”) can have a profound effect on the eventual size of your portfolio, particularly during retirement when you might have to “sell low” to pay for golf and groceries. On the other hand, I’ve not written nearly enough about some of the other risks investors have when saving for retirement, such as running out of money due to not taking enough investment risk: GIC investors, this might mean you! If your money needs to last you through 30 plus years of retirement, settling for investment returns that might not even keep up with inflation after including taxes potentially means tough times if you live into your 90’s (or 100’s if some of those alleged medical advances actually pay out) unless you’ve got other assets that pick up the slack or have either have or will later inherit a healthy nest egg.

Structured Notes – What Are They?

Although I love the regular income that GICs can produce and appreciate the peace of mind that comes with the typically complete capital protection, I’m willing to take a bit more risk to hopefully reap a lot more reward. Although there is no silver bullet perfect for every occasion and every market, I’ve found a few tools that can produce a significantly higher income without dramatically increasing the risk of getting birthday cake on my snazzy new pants. In other words, while I’m taking on more investment risk than a GIC, I’m also giving my portfolio a chance to at least keep up with inflation to combat longevity risk, — otherwise known as the possibility of having to survive entirely on bologna sandwiches later in life. Today’s offering talks about one of these tools designed to thread the needle between investments that are too unpredictable and those that too stingy: auto-callable contingent income notes, a subclass of a class of investments known as structured notes.

In general, structured notes are investment products created by banks that track the performance of underlying investments and pay investors according to how that particular underlying basket of investments performs. The banks issue a bunch of different notes with different potential returns based on different underlying investments, ranging from the performance of the entire TSX, a basket of a few stocks, such as the big 5 banks, or even the performance of a single stock, such as Tesla.

In many ways, structured notes are like betting on sports, although with typically far less risk than overzealous Leaf fans may have experienced over the years. The banks offer an ever-changing array of notes, each with different potential outcomes and levels of risk, depending on current market conditions. Investors investigate the different notes and place their bets based on their assessment of risk and return. Like any good bookie, the banks cover their risk by purchasing options or zero-coupon bonds in the investment market that match the terms of the notes on offer so they are not out of pocket if the investors win. In fact, both the banks and the investors have something to celebrate if this happens– since someone else will ultimately be financing the investors’ profits, the bankers are still smiling because they got to use the investors’ money along the way, minus the cost purchasing the protection, to do bank-like things, like lending it to other clients or investing it for their own profit.

Although there are a wide variety of notes on the market, I just want to talk about one type– auto-callable contingent income notes, a name obviously not chosen by an advertising professional. This product provides a regular income stream provided that the underlying investments doesn’t drop below a predetermined limit. It is typically considered a hybrid of both stocks and bonds – the returns are based on the performance of stock, but investors don’t participate in the growth of the underlying investments (although there are other structured notes that offer this feature if you’re so inclined.) Instead, investors get a constant payout for each specified period (such as monthly, quarterly or annually), much like a bond unless the underlying investment has dropped more than a preset amount as of a specific day. Also, unlike stocks, any proceeds from notes are almost always taxed as interest.

The Value Proposition and an Example

The best way of truly describing this class of notes is by way of example. Although I’ll recklessly throw some investment jargon your way, keep reading and hopefully all will soon become clear. A typical note issued in today’s high interest and uncertain times might offer 12% annual income paid monthly (each payment is called a “coupon”) based on the underlying performance of a basket of Canadian banks with a 30% barrier and a 30% partial maturity guarantee when the note matures in 7 years (although 5- and 3-year maximum lifespans are also common) with a 110% autocall feature. Translating into English, this means that so long as your basket of bank stocks hasn’t declined in value more than 30% from the date the note was issued on a preset day each month, you earn that month’s interest coupon. If, instead, financial Armageddon hits and your basket of banks is down 35% on the day in question, you miss that month’s payment. The next month, however, if the banks have rebounded even slightly to 71% of their original price, you earn that month’s income, although last month’s lost interest remains lost and gone forever most of the time.

This monthly calculation continues until one of 2 things happen – either the underlying basket appreciates by more than 10% of its original value (the “autocall” price) or 7 years have passed and the note “matures.” In the first scenario, investors get their final interest payment, plus all of their original investment back as of the month the basket hits its target growth rate. In the second situation, it all depends on the value of the basket at the time of maturity, plus the amount and type of downside protection purchased. In the example I’ve given, which is a 30% “barrier,” at maturity, if the basket is worth at least 71% of the original value at that time, then the investor gets a full refund of the original purchase price and their final interest payment. On the other hand, if the investment is only 69% of the original value, then they would only receive $69 of the original note. Put another way, this investor gets all their money back so long as the underlying bank bundle hasn’t declined by more than 30%, but, if it has, they are on the hook for the entire loss.

If the latter outcome is too risky for your blood, you might purchase a note with a “buffer” instead. While a barrier provides protection if the loss is within a certain range, buffer notes offer protection even if the loss exceeds the preset threshold. Using my previous example, if you owned a 30% buffer instead of a 30% barrier and the basket was worth $69 at maturity, you’d still get back almost all of your original investment, although your monthly interest payments would likely have been less than those offered through a barrier note. As you’d expect, you pay for this extra protection by accepting a lower yield since the bank has to buy more expensive protection to cover the potential loss.

Other ways to Protect Yourself

Although buying a buffer dramatically reduces downside risk, that is not the only way of increasing your odds of a positive outcome. Here are some other tactics to increase the chances of a happy ending:

Increasing the size of the buffer or barrier. Is 30% not enough protection to protect the quality of your nightly slumber? Consider buying 40% downside protection instead, both to protect your regular income and how much you’ll get back if the note isn’t redeemed until maturity.

Purchase notes with a memory feature. Although being under water on the observation date typically means losing that period’s payment forever, notes with a memory feature allow you to play catchup. Once the note is once more above its barrier or buffer on a future observation date, the investor gets both their regular payment plus any payments they may have missed in the past.

Buy notes that go low. There are occasionally notes that calculate the initial value of the note for future observation date purposes based on lowest value of the underlying bundle within the first observation period. For example, a note with a semi-annual coupon based on the TSX with a 30% barrier with this additional feature would pay that half-year’s coupon so long as the value on each observation date was at least 70% of the value of the TSX at its low point during the first 6 months after the note was issued rather than the bundle’s original value at the time the note was issued.

Opt for monthly coupons. If there is a precipitous decline in the value of the underlying investment on an observation date, it’s far better if you only miss one month’s coupon payment instead of perhaps an entire year’s worth. Different notes offer different payout periods, such as monthly, quarterly, semi-annually or yearly. Since a really bad day in the market on the observation date means not getting paid, picking the monthly coupon option means only missing one month’s worth of income if the investment world is far less dire a month later. Although picking shorter payment periods can cost you the occasional payment if the bundle is underwater for a month or two but rights itself by the end of the quarter or year, I’d much rather accept this risk than chance risking an entire year’s worth of income by selecting a note with longer gaps between payments.

Picking a boring bundle. Hedge your bets by picking a note based on an underlying investment you think is conservative or which you view as already significantly discounted. As an added bonus, because of this recent volatility, notes based on investments with a recent decline generally offer higher coupon payments. Some clients recently purchased notes based on Canadian banks for these reasons, for example. It is even possible to purchase a note based on an entire index like the TSX rather than a specific sector to if you feel that this is a safer bet.

Pushing out the lifespan of the note. The duration of the structured notes can also vary. One school of thought suggests that the further out in time before a note matures, the smaller the chance that the underlying basket will be less than the protection purchased at that time. If you believe that the market ultimately wins in the end, increasing the distance between purchase and the maturity date plays into this philosophy. Moreover, since notes can also be sold on the secondary market, notes with a longer maturity period aren’t as volatile if you need / want to cut bait and sell along the way.

Selecting the autocall carefully. Most notes do not make it to maturity. In fact, the majority are redeemed within a couple years of issue. Sometimes this is a good thing and sometimes, not so much. If you love the interest rate and the underlying basket, look for a higher autocall threshold such as 110% of the original bundle value vs. 105% so you can keep raking in the cash for a bit longer. On the other hand, perhaps you just want to park your money in a note until you feel better about the market and / or don’t love current note rates. If you have an autocall feature where you’re redeemed when the investment climbs by only 5% vs. 10%, you will be bought out potentially far sooner if the investment performs, at which time you can redeploy your capital into either another type of investment or perhaps another note with more favourable terms.

Purchase a note with the right initial observation date. Even if you have a monthly autocall feature, your note will have a minimum initial waiting period before the autocall feature kicks in. If you love your current note, picking perhaps a 1-year initial observation date vs. 6 months may help keep the good times rolling that much longer.

Buy a bundle of bundles. Rather than just purchasing a single note based on a single bundle, spread out your risk by purchasing several different notes based on different underlying investments. In fact, structured note ETFs have recently come onto the market in Canada. Although the one I investigated is too new and has only 20% barrier protection, who knows what will be on offer in a couple years or how existing products have performed.

Pick a note that matches your ultimate time horizon. Although most autocall notes are redeemed within a couple of years and there is a secondary market should you wish to sell, consider matching the ultimate duration of your notes to when you need the money. For example, if investing in a TFSA to purchase a home in 5 years, a note with a 7-year maturity period might not be the one for you. As stated earlier, however, if you really need the cash, there is a way out. In fact, structured notes may be cheaper to unload in some situations than non-cashable GICs, depending on how your note is priced in the secondary market.

Don’t be a one trick pony. No matter how much you like this type of investment, continue to diversify your portfolio with different types of investments. For GIC fans, this might mean combining structured notes with a few GICs as well in order to further reduce your risk. Ditto for those investors who are big on bonds, preferred shares or perhaps other investments like Mortgage Investment Funds, which I see as the main competitors, although each has their own pros and cons.

More Note Planning Tips

In no particular order, here are some more tips to consider when looking into purchasing notes:

Shop around. Not all banks offer the same rates at the same time. If your broker is linked with one of the big banks, make sure that (s)he also looks at what the competitors are selling.

Realize that notes pay interest and plan accordingly. Although notes are based on an underlying bundle of stocks, all distributions are taxed as interest income. Accordingly, they are best owned in registered plans, family trusts with low-income beneficiaries or by low-income individuals not worried about things like the GIS clawback.

Focus on the big picture when assessing risk. When choosing between this type of product vs. alternatives like GICs, preferred shares and bonds, consider the risk of a note being redeemed for less than full value at maturity but also the extra income you may have received along the way vs. some of these alternatives. It could be that the extra cash received before then from a higher yield, particularly if you have buffer protection that absorbs most of the loss, still leaves you better off than something like a GIC with 100% principal protection but a much lower yield. Do a similar analysis if deciding how to allocate money among investments like notes, bonds and preferred shares, although you’ll also have to factor in the chance of those other options producing capital gains or losses (although this could also arise if trading structured notes on the secondary market.)

Get your broker to custom-fit a note. Like a good bookie, banks are typically willing to create tailor-made notes for the right client if worth their while ($1 million seems to be the minimum note size.) Accordingly, if you can’t find the exact note of your dreams, see if your broker or portfolio manager is willing to work with a bank to create a custom fit. It’s not like you’d have to purchase the whole thing – my own portfolio manager is currently working to create one that a bunch of his clients will share, plus whatever other investors may snap up.

Performance Notes

The following stats, plus many useful tweaks and suggestions, were provided to me by two Portfolio Manager friends at Aligned Capital – Thomas Tsiaras and Wail Wong. A big thank you to both of them for their expert advice.

The following chart pertains to National Bank products from 2016-2022. Our notes of choice, auto-callable contingent income notes, are included as part of the “Non-Principal Protected Notes” family, as opposed to the “Principal Protected Notes.” The first category covers notes that include only partial protection (an average of 32.7% downside coverage) while the second cluster fully guarantees that investors will not lose money.

While the fully protected notes, including market-linked GICs (which are not be confused with your guardian variety fixed income GICs) did ensure that no one lost money, they only produced an average annual return of 3.3%. In contrast, notes with partial protection averaged an annual return of 8% even after factoring in losses. Moreover, the partially protected notes failed to make a profit only 2% of the time, versus 24% for notes with full coverage. In other words, in exchange for taking on this extra risk, which only resulted in neutral or negative outcomes 2% of the time, the investors earned more than twice as much than their more conservative friends, with a higher chance of making money.

Diagram

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Fee Classes

Notes are either sold as “A” or “F” class, just like many other types of investments, either with an embedded commission for the advisor (A Class) or with that commission stripped out, with advisors charging their clients an advisory fee directly (F Class.) As you would expect, F class notes offer a higher yield.

Some advisors may offer clients the choice of purchasing either class of notes – those with a one-time fee embedded into the product but with a yield that is adjusted to cover these costs or those with the commission stripped out but with ongoing advisory fees paid directly, although this will likely require clients who purchase both versions from the same advisor to hold them in different accounts, one managed by the advisor and the other self-directed. In some cases, choosing the Class A notes can even be a win-win for both client and advisor – the lower A class yield may be less than what the advisor charges management fees, but the advisor still makes a healthy one-time commission, particularly if the note is sold or autocalled within a couple years and the clients reinvest the proceeds with that advisor.

Conclusion

Although they have been around for a while, auto-callable contingent income notes are currently one of the trendiest investment options for clients looking for higher yield with some extra protection. Although they may have more moving parts than a caper movie, don’t let that scare you off from putting in the work to see if they have a place in your own investment portfolio. The retirement you save might just be your own.

Dec 11

Is Mortgaging Your Future Necessarily a Bad Thing – Investing in Morgage Investment Corporations

Over the last 2 years, the economic landscape has undergone a seismic shift. Interest rates and inflation have both spiraled to levels not seen in decades – the last time Bank of Canada interest rates reached current levels was prior to the 9/11 bombings. And, although inflation has dipped from its peak, we have still been dealing with inflation not seen since I was in high school, a period long since vanished into the mists of time.

These enormous changes, coupled with recent stock market declines and concerns over further market retreats have left many investors befuddled and bewildered, particularly those looking for fixed income returns that actually do better than inflation after paying off the tax man. Although GIC rates have also risen to the occasion, when both inflation and tax are factored into equation, their buying power is at best treading water and at worst, submerged by the waves. Consequently, many investors are clamouring for higher yielding investments that don’t make them feel like they are plunking their money down at a craps table, hoping not to roll snake eyes.

I’ve recently written on a type of structured bank note with significantly higher yields that GIC with some downside protection but want to spend today talking about another option: Mortgage Income Funds or “MICs.” For the rest of this article, I’ll outline what they are, how they work, and key factors to consider so that you can decide for yourself whether they are worthy of a special place in your life – inside your retirement portfolio. Thanks to Russ Mortgage, mortgage broker extraordinaire, and both Thomas Tsiaras and Wail Wong, portfolio managers at Aligned Capital, who regularly incorporate MICs in their client portfolios, for their valuable input.

The Basics

Background and Basic Features

MICs are investment funds created by the Federal government in 1973 that hold a pool of mortgages and which are required by law to pay out their yearly after-tax earnings to their investors. In return, the government doesn’t make MICs pay tax directly, which means more for investors, unlike most other types of investments, where companies have to pay taxes on their earnings and can only distribute whatever is left (although the dividend tax credit on eligible dividends can admittedly ease the pain in non-registered accounts.)

On the other hand, even though MICs may describe their distributions as “dividends,” they are taxed as interest or income by our friends at the CRA. As a result, MICs are not tax efficient and are often better owned inside registered accounts like RRSPs and TFSAs.

MICs play a surprisingly large role in the lending business. One recent article suggests that there are between $13 and $14 billion invested in MICs in our country and that they account for about 1% of the mortgage market. Another, slightly older, article suggests that there were over 200 MICs in Canada as of 2018. In other words, there are more MICs in Canada, and they are collectively worth far more, than most of us realize.

As you might expect, all MICs are not created equal. Each has its own investment mandate and strategy. Some may lend across Canada, while others focus on distinct geographical areas like the Lower Mainland of BC or Greater Toronto. Some only lend against residential properties while others lend to commercial developers. Perhaps most importantly, some seek higher returns by issuing second or third mortgages while others focus primarily on first mortgages. Different MICs also have different loan to equity rules – more conservative MICS may lend $.65 or less per dollar of collateral while other MICs may be willing to lend as much as $.85 per dollar, and as a result, paying higher distributions. Yet another recent article ranged expected returns across the MIC universe this year between 6 and 12%.

Finally, there is one more significant difference distinction between MICs– some trade on the stock market and are subject to fluctuations in value like a stock, ETF or mutual fund, while private MICs generally maintain a fixed value of $10 per unit so that investors’ total returns will be limited to interest earned. Private MICs are not nearly as liquid as public offerings and don’t have the same reporting requirements, but each investor’s ultimate returns are not dependent on the whims of the stock market on the day he or she decides to cash in. As in so many areas of life, there are pros and cons to any decision.

In summary, all MICs are not created equal and each of us needs to carefully look into the different alternatives before deciding whether or not to invest and, if so, which MIC or which basket of MICs offers you the best mix of safety, returns and quality sleep.

The Business of Private Lending

As you’d expect, people usually turn to alternative lenders when they can’t qualify for a traditional bank mortgage or the banks won’t give them as much as they want. Although poor credit history is always a reason why some people bail on the banks, it isn’t the only one. Here are a few other types of typical MIC borrowers:

Recent Immigrants Recent immigrants may not have been in Canada long enough to establish a sufficient credit history to fit within the bank’s lending box and may need to work with an alternative lender until they have been here long enough to build up the necessary track record.

The Self-Employed and Commissioned Salespersons. The self-employed are generally seen as a big risk, particularly if they have unstable earnings. Likewise, commissioned salespeople are often viewed through a similar lens. Moreover, regardless of how much money someone with a private company may be banking up in a holding company, the banks focus on personal income, ignoring additional corporate earnings that could have been paid out but were not, generally for tax reasons. In some cases, these clients may simply need to bump up their own salaries, work with a MIC in the short term and then circle back to the banks in a year or so. In some cases, the big banks are actually the ones that refer clients to alternative lenders in the expectation that the clients will return to the banking fold in the not-so-distant future.

Quicker Approval. In some cases, property developers may choose to work with private lenders, particularly for shorter term loans because it is easier and faster.

The Mortgage Stress Test and Its Impact

The stress test was introduced in 2018 and has resulted in many potential borrowers previously on the side of the banking angels no longer qualifying for a traditional mortgage, despite solid credit scores. As alternative lenders, such as MICs, aren’t bound by the stress test, they can adopt their own flexible lending policies and fill the gap when the banks say no. Ultimately, this increases both the size and quality of pool of borrowers MICs can choose amongst. On the other hand, many MICs have been growing like gangbusters since 2020, which might erode some of this benefit.

For those of you who are normal people (i.e. aren’t up to speed on all things stress-test), the basic rules are as follows. Borrowers working with the banks must be able to qualify for a mortgage at whatever rate is higher: 5.25 % (this rate is reviewed yearly) or 2% more than what their bank is offering them without using:

More than 39% of their pre-tax income to cover the mortgage and other housing costs, like utilities and property taxes; and

More than 44% of their pre-tax income to towards all personal debts, including the mortgage.

To put how much interest rates have climbed into perspective, the 5.25% is so out of date (borrowers have to be able to sustain mortgages between 8 and 9% as of early December 2023) that most people successfully applying for a mortgage will be paying actual interest that is higher than preset stress-test rate. The rate surge that the 5.25% minimum rate was designed to insulate has now arrived in full force and now seems to have stalled. Accordingly, the stress test has saved many borrowers from a world of hurt or will at least reduce their pain when it is time for them to renew over the next few years by capping how much they were able to borrow when the getting was good. On the other hand, if you believe that we are primed for interest rates to finally start falling or at least not to grow by another 2% over the next 5 years, then you may feel that the stress test is now getting in the way people and banks’ ability to think for themselves. That’s where MICs play a role.

Factors to Consider When Comparing MICs

Although I’ve already discussed some of the key differences between various MICs in passing, here is a more detailed summary:

Type of Mortgages. Different MICs lend against different types of real estate. Some may lend to developers or other investors, while others restrict their loans to homeowners. I personally prefer residential mortgage MICs in the belief that homeowners will move heaven and earth to protect the place where they and their family sleep at night vs a corporate developer that is protected from personal liability if things go wrong.

Geographic Considerations. Some MICs focus on Canadian real estate while others will also lend outside of the country. Moreover, within Canada, some MICs target specific areas, such as BC’s Lower Mainland or Toronto, while others sprinkle their loans further afield. There are different benefits and risks to each approach. For example, a MIC focusing on a specific geographic area may be able to understand that market better than a MIC with greater geographic diversity and may be able to build up better connections and quality of borrowers than a MIC without a homecourt advantage. On the other hand, as all of us investors know, diversification has its own advantages.

Downside Protection / Loan to Value Ratio. How much does the MIC lend per dollar of equity in the property? And, how much extra does a higher paying MIC generate for taking on this additional risk? I generally restrict myself to MICs who lend no more than approximately 75% of a property’s equity, but each to their own.

Priority of Mortgages. Some MICs (often called “Prime Mortgage Funds”) only issue 1^st mortgages while others may blend in some 2^nd and 3^rd mortgages. Determine the mix (see what I did there) of different mortgages in each MIC and how much fits into each category. As well, how much (or how little) yield do you give up by investing in a fund that only provides first mortgages?

Average Loan Size and Number of Mortgages. I believe that the greater the total number of mortgages and the smaller the size of the average mortgage, the better the protection.

Average Value of Borrowers’ Property. I prefer MICs that focus on starter homes, as I see them as more resistant to market drops than swanky luxury pads. As the value of a starter home in Halifax is a fraction of Toronto number or Vancouver values, it’s also a question of knowing what a starter home costs in that MIC’s target area so you can determine if the MIC is focusing on entry level residences or palatial estates.

Leveraging? Some MICS boost returns by borrowing from banks or other lenders at one rate and then lend the money out to borrowers at higher rates. The bank or other financial institution working with the MIC will have done its own due diligence before agreeing to this arrangement and will continue to monitor things closely, but you will need to decide for yourself whether you’re okay with this. I also suggest determining how much a fund is currently leveraged and the maximum amount it can borrow.

Liquidity Restrictions. Private MICs usually have a minimum holding period and only offer redemptions monthly or quarterly, which means waiting another month or two at least from when you want your money back. If a minimum holding period applies, determine the penalty for cashing in your chips early in case your plans change. Private MICs, like other exempt market investments, can also can “gate” or restrict redemptions in exceptional circumstances, such as if too many people want to redeem at once. This is potentially one of the biggest disadvantages of private MICs.

On the other hand, it’s also important to keep things in perspective. Although public MICs can’t gate redemptions, if there is a run on a public MIC, expect to sell at a significant discount. A private MIC that gates redemptions may ultimately allow cooler heads to prevail so that investors ultimately get do better in the long run. In any event, doing your homework prior to investing can go a long way towards avoiding things going wrong later.

Term to Maturity The shorter the duration of a MIC’s portfolio of loans, the less time for things to go wrong and less time for the value of real estate to decline enough for my equity to be at risk if it does. Many MICs focus on 1-to-2-year loans, although the average duration of loans may be even less than a year.

Public vs. Private. The typical pros and cons of public vs exempt market investments apply to the MIC world like they do public or private REITs. As I’ve mentioned the key issues earlier in this article, I won’t rehash them now. For those of you who have never purchased an exempt market investment, however, you will ultimately need to sign the standard acknowledgement that states that you know you could lose all of your money, regardless of its track record and downside protection. Strangely enough, there is no such requirement when purchasing a penny stock on the TSX.

Track Record, Management Team, etc. Like any investment, you’ll want to look at how long they have been in business, who is calling the shots, the company size, the continuity of their management team, whether they have missed any payments and ever gated redemptions.

Deal Flow and Growth. I like to know where a fund gets the majority of its clients and how quickly a MIC has grown. I also want assurances from MICs that have grown quickly that they aren’t scrapping the bottom of the borrower barrel simply in order to deploy funds. It’s actually a good sign to me if a fund refuses to accept new money from time to time if they don’t feel they can deploy it prudently, as this shows a responsible management team.

Average Credit Rating. Although this won’t tell the full story, it’s useful to know the average borrower’s credit rating and how this has changed over the life of the fund, particularly over the last few years if a MIC has been growing on steroids.

Default Rate and Loan Loss Provisions. How many mortgages are in default or trending in that direction, what is the fund’s typical default rate and what sort of default assumptions are baked into their projections when calculating their yearly distributions? A Portfolio Manager friend of mine has a personal favourite that has never had a single mortgage default in its 14 years of existence, although that doesn’t mean they shouldn’t continue to plan for the worst. A healthy MIC will have a low default rate well below the rate used for its forecasting. As different provinces and states have different foreclosure rules and timelines, knowing how things work in that MIC’s prowling grounds can give you an idea how long it will take to convert real estate into hard cash so the money can be reinvested.

Minimum Purchase and Qualification Criteria. For private MICs, some require at least a $5,000 initial purchase, while others may require significantly more. There are also restrictions on qualified investors, based largely on their income and / or net worth.Moreover, not all MICs have the same minimum investment limits. In some cases, investors may need a sizeable income or over $1m in investable assets, while others may be accessible for those with a lower income and over $400,000 in investable assets. Once more, although anyone can buy a penny stock and invest as much as their heart desires, not everyone is eligible to invest in a private MIC or allowed to invest as much as they would like.

Information Flow. For private MICs, determine how often they will provide you with information updates and what sort of information you might receive. Some provide monthly newsletters.

Variable or Fixed. MICs that only issue variable mortgages have been able to raise distributions in lockstep with increase in the Bank of Canada’s lending rate, which is also a great inflation hedge. One of my MICs with variable-only mortgages literally increased distributions within an hour of the B of C rate decisions on many occasions. Those with fixed rates aren’t as nimble but will likely be able to sustain rates for longer once the Bank of Canada changes direction. Accordingly, a fixed rate portfolio with a longer average loan duration might sustain higher rates longer if interest rates decline, assuming their borrowers meet their commitments.

Fees. Although distributions from MICs are net of fees and I have no problem with good people getting well compensated, I still want to know what I’m paying. Moreover, sometimes, the management fee doesn’t tell the whole story, as MICs also typically charge borrowers a loan origination fee. Some MICs pocket this themselves in addition to their ongoing percentage management fees while others share the revenue. Accordingly, sometimes the basic management fee doesn’t tell the whole story.

CHMC Insurance. Most MICs do not have their mortgages insured with the CMHC.

Timing of Payments. If you are looking or needing monthly cashflow, then funds with monthly distributions are likely the ones for you. If this isn’t as vital, there are other funds that pay less frequently, such as quarterly.

Conclusion

Although MICs have been around almost as long as we’ve been taxing capital gains, many investors have never heard of this particular acronym, let alone added it to their investment portfolio. Like all categories of investments, there are the good, bad and the ugly. If you’re looking for a higher yielding investment and are looking for alternatives to traditional options such as bonds and GICs, MICs might be worth a second look. And, if that second glance turns into a desire to invest, please be sure to ask the tough questions so that you ultimately end up with the MIC (or the basket of MICs) of your dreams.

Apr 13

Playing With House Money #2 – Gifting, Loaning or Co-owning?

In my last article, I discussed many of the different ways that Canadians hankering to eventually own their own home could best save towards funding this dream. Today’s offering discusses the three most common options available for parents when the youngster wants to buy a home but needs a little more help to get them across the finish line when it’s time to purchase:

Gifting;
Loaning; and
Co-owning.

And, although the article discusses parents helping children, I’ve only done this to make this article easier to write- the options discussed apply to anyone looking to help a family member or even a really, really, really good friend get a place to call their own.

Overview

Before going advancing any money, I strongly suggest first taking a step back and having a heart-to-heart conversation with yourself. Some of the questions you may pose are:

How will helping impact your own financial future? How much could you safely loan or gift without risking a future full of Kraft Dinner during your so-called Golden Years?

Are junior’s financial forecasts realistic ones? And, are you prepared and able to commit more money in the future if (s)he has bitten off more than (s)he can financially chew? In some cases, you all may ultimately be better off if junior scales down their dreams so that (s)he can have both a comfortable home and a comfortable lifestyle.

How secure is the child’s relationship? Not only will this affect whether or not now is the time to advance some funds, but the form this assistance might take.

Is struggle good for the soul? And, is it possible to be too generous? Will this particular child benefit from having to save a little longer, scale down expectations or struggle with the responsibility of living on a tight budget? Or, does this parsimonious approach merely make life needless harder while simultaneously depriving you of the benefit of watching the next generation enjoy the fruits of your generosity? Feel free to insert any additional existential questions of your own.

Meet Your Options

Should you still wish to help after wading through this swamp of difficult questions, the next issue is what form of assistance is best. Here are the leading contenders:

Gifting – Simple but Risky

Assuming that you will never need the money back, this option is the simplest and often works out just fine. All the same, allow me to don my legal robes and point out some of the things that can go wrong, sprinkled with a few suggestions about how to limit your risk:

If your child is successfully sued, your gift is up for grabs.
If junior is financially irresponsible or faces problems like gambling addiction, you don’t have the same financial clout as someone who is a lender or co-owner.
There is no guarantee you’ll ever get the money back if you later discover that your child is married to Bernie Madoff’s evil(er) twin. It is often better to give (or loan) a little less than to risk running short of cash yourself when a super senior. You can always give more later once your own financial future is more certain or when your kid demonstrates that they are not a complete financial train wreck.
Although most provinces protect the amount of a gift in the event your child divorces, (s)he will still have to divide any growth in the place’s value 50/50. And, in provinces like Ontario, gifts used to purchase the family home are ignored when divvying up the matrimonial pie. In other words, if a marriage based in Barrie doesn’t work out, half of your generosity will end up in the hands of someone your child may now cross the street to avoid. Is this a risk worth taking?
If your child dies first, you have no control what happens to your gift. While most parents wouldn’t mind so much if the gift passed to their grandchildren, you might feel decidedly differently about a $200,000 gift passing to a son/daughter-in-law you can’t stand or some random charity a single child might name in their Will, particularly if you have other children that you’re rather received the funds.
If planning to gift to other children in the future, do you need to include language in your Will to equalize things at that time if you don’t get the chance to do so during your lifetime?

If gifting still sounds like the best option, I suggest actually going the extra mile and documenting your generosity in writing in order to avoid potential legal problems later. If your intentions are unclear, the law assumes that any funds paid to adult children are loans, rather than gifts. Accordingly, if your kids don’t get along, or your new wife isn’t the biggest fan of your old kids, your gift to those children may be unintentionally clawed back when you’re 6 feet under. Lawyers prepare something called “a deed of gift” that puts this issue to bed. Not only can these documents ensure that your child gets to keep the gift, they can also hopefully avoid hard feelings over Christmas dinners after your ashes have been scattered over your favourite golf course if other family members had a different understanding of your intentions even if they don’t involve lawyers.

And, if you are planning to help other children in the future, consider whether you want those children you didn’t get a chance to help during your lifetime get a bigger share of your estate later. If the answer is yes, also consider whether you need to bump up the value of any post-death equalization payments in your Will to take into account things like inflation and what planners calls the “time value of money.” Put another way, a gift of $100,000 5 years ago is worth a lot more than a similar gift made today – do you need to adjust any equalization payments to take this into account?

Loans – Help with Strings Attached

9 out 10 lawyers prefer lending over gifting 95.2% of the time when the size of any cash advance is at least 6 digits long. It’s not always because of the things we can anticipate going wrong, but because of the things we don’t. Knowing that we can’t predict everything that might go awry, we like to keep our options open just in case. Unlike gifts, loans can be called in if parents do need the money back, the child gets sued, has a failed marriage, likes to bet on the ponies a little too much or (insert reason of your own.) It’s not like you need to charge interest and it’s always possible to forgive the loan at a later date, such as in your Will – it’s simply about adding a little extra protection and flexibility to our clients’ planning.

If you’re pretty sure you might need the money back or are actually having to borrow yourself to help the child get that housing toehold, a loan becomes an even better idea. In such cases, perhaps you do charge the child interest equal to your own borrowing costs, such as if you’re using your own HELOC to come up with enough money to get the child into a bungalow. I’ve even heard of some parents taking out a reverse mortgage to help the child get started, although I worry about what happens if mom and dad ever need to go into assisted living and most of the equity in their place has essentially been transferred into junior’s abode.

If going the loan route, here are few options, recommendations and consideration to chew on:

Review the law regarding division of property in the event of a divorce. Many provinces protect the sum originally gifted to a child if (s)he divorces, even if any increase in the home’s value is still split 50/50. On the other hand, this is not a universal law and if you live in Ontario, any gift funneled into the family home is unprotected. Accordingly, since loans remain enforceable, gifting rather than loaning can be an expensive mistake if your daughter’s marriage later unravels at the seams and she happens to live in Barrie, as mentioned earlier. (To be clear, I actually quite like Barrie, just not Ontario’s spin on how the house is divided upon divorce.)

Document the gift in writing, preferably in front of an independent witness, so you can prove both that it was a loan and its terms. On the latter point, if you are looking to charge interest or have a repayment schedule, documenting the intentions in writing may avoid some misunderstandings and awkward conversations down the road.

If charging interest, consider a variable rate loan pegged to a benchmark, or, if you really, really like fixed-rate mortgages, include rate reset provisions further out in time, such as every 5 years, as well as a formula, such as pegging rates to bank rates at that time for a similar mortgage. Although you may not always pass along any rate increases, it’s a lot easier to waive or modify terms in the future if you’re feeling generous than to ask for a rate increase out of the blue later in life when you’re charging 5% less than current mortgage rates or what you’d hope to get if investing the loan money elsewhere.

If really worried about protecting the loan, such as if your child is not exactly a financial superstar or they might sued at some point in the future, consider registering the loan against the property like banks do when providing mortgages. On a practical level, if the child also has a bank loan, this may present problems or you may need to grant the bank the right to get paid first if there is ever a forced sale, but this option is at least worth investigating if you start to hear about your child missing credit card payments.

Consider requiring your children to sign a prenuptial as a condition of a loan if his or her spouse or their family aren’t contributing as much towards any home purchase or your child goes into the relationship with a lot more wealth, particularly if (s)he already has children from a previous relationship. This might be the pretext your child was looking for but was too love-struck to bring up in casual conversation. You playing bad cop, albeit one with a large cheque book, may ultimately save your child a lot more than the value of any loan should their relationship go south. Moreover, prenups and cohabitation agreements also cover off Will challenges. Although your child may not live to see the benefits of the prenup, his or her children may be the ultimate winners when the stepfather or stepmother of your grandchildren is prevented from claiming more of the estate at your child’s death than your child had wished and bargained.

Make the loan to both your child and their partner so that you can potentially collect from either of them. This provides you with more protection and flexibility. For example, on your child’s death, it is easier to collect from the spouse or at least protect the value of the loan if the spouse enters into a new relationship. Some parents may still forgive the loan at their own death, but others like the idea of gifting the remaining loan balance to their grandchildren in trust in order to ensure that they get at least that much of the house one day.

If you do need the money back one day, be clear on a timeline, such as an event like retirement, your 65^th birthday or when the child renews the bank mortgage in 5 years. Not only does this help with setting expectations, but it also allows your child to budget for this eventuality when managing their own finances, which vastly increases the chance that (s)he actually has the resources to make this happen when the target date arrives.

Talk about the loan in your Will. If you plan on forgiving it, say so. If you want it deducted from a child’s share of your estate instead, say that as well. If nothing is said, it will be treated as a loan to be repaid most of the time, but why leave it to chance? Even if that is your intention, any uncertainty can lead to bad feelings among the rest of the family if they don’t agree on what you really wanted to happen. And, if you want the loan transferred to someone else, like a grandchild, say that as well.

As mentioned earlier when discussing gifts, if you haven’t loaned to your other children at the time of your death and have interest-free loans to others, do any equalization payments to the have-not kids need to be bumped up beyond the mere value of the loan to level the playing field? Consider charging notional interest (but don’t make the calculations too complicated) to increase the amount of any equalization payment. For example, I have had some clients add amounts like 5% per year to the value of any previous loans when determining how much the loan-free children should get before the rest of the estate is divided.

Going on Title – Helping But Not Necessarily Giving

There are several different scenarios where mom and dad might actually end up on title to a child’s house. I won’t pretend to cover all of them, but I’ll point out a few scenarios where this might either be required by the bank or something you might want to do for other reasons.

The most common situation is when the child can’t qualify for mortgage on their own and the bank won’t give them the cash unless you’re both on title and are also responsible for ensuring that the bank gets their biweekly pound of flesh. Although it is theoretically possible for you to stay off title but only guarantee the mortgage, I haven’t seen this actually happen, unfortunately. Typically, the parents required to be on title take a 1% interest (although you may want a bigger stake as I’ll discuss later), which is the minimum amount necessary to appease the bankers. If this is unavoidable, so be it, but lawyers really do hate it when clients end up guaranteeing someone else’s loans, which is what you’ll be doing when signing onto the mortgage. It’s one thing to write a child a cheque for a set amount and knowing that is all you might lose, but something completely different to know that you might be called on to make someone’s ongoing mortgage payment or perhaps a lot more. Although there will hopefully be enough equity to pay the bank back should this happen, there are no guarantees. Moreover, it is generally a lot better for Christmas dinners in the future when family finances aren’t connected at the hip. Anyway, if guaranteeing or being a copayer of a mortgage is the only way forward and you’re comfortable with the situation, at least proceed with your eyes wide open.

In other cases, perhaps mom and dad want more than just a thin slice of the new place. For example, if they are providing a 30% down, they might want 30% ownership. For parents considering taking on a larger ownership stake, here are some more of the pros, cons and suggestions, using this 30% ownership example:

If a child’s relationship fails, you are entitled to at least 30% of the equity rather than just the amount you originally contributed. On the other hand, this may not be as good as it sounds. If the place has declined in value, you might get back less than you invested. Moreover, if you have funded the entire down payment and the rest was mortgaged, your 30% of the equity may actually be less than your original contribution even if the property has gone up in value. For example, if you contribute the entire $300,000 downpayment for a $1,000,000 property and take back a 30% ownership stake, you could potentially still lose money if the property sells the next day for $1,100,000. Although the total equity has increased to $800,000, unless you have a proper agreement in place that ensures that you get your original contribution back first, you may only be entitled to 30% of $800,000 or $240,000. Accordingly, a written agreement is a wise insurance policy for any time you’re co-investing with a child, particularly if they have already coupled up or might find that special someone in the future.

“Going on title” ensures that the child cannot sell or borrow additional funds against the property without your knowledge, and in most cases, consent. If you merely have a written loan agreement without registering a mortgage against the property, your child can do as they wish. For younger or troubled children, or if you have control / trust issues, this may not be an acceptable risk.

You’ll have more to pass along to grandchildren or others compared to merely calling in a loan or transferring it to grandchildren if your child predeceases you. Although transferring a loan to the grandkids does provide some benefit, the value of any loan will not have increased along the way and the spending power of any loan 15 years down the road is likely a fraction of what the money was worth initially, which means a lot less to pass along to junior’s own children in real dollars. If you have a piece of equity to pass along instead, hopefully the value of your piece of the pie will be a lot more significant.

Unless you’re also living in the house with your child, which is something becoming more common, your percentage of the property probably won’t qualify for tax-free growth under the principal residence exemption. While your child’s share of their home will still sell tax-free, your portion of any growth will be taxed as a capital gain. If weighing choices, particularly if you don’t need the money back and plan on gifting it to the child at death, the tax hit that could have been avoided if the child was the only one on title is one of the biggest negatives. Noting the typically high tax rates people face at death, this could mean losing 26.75% of any increase in value to the tax man.

If you have to borrow to come up with the money and may be cash-strapped for your own retirement, taking an equity position, along with that written property agreement I am harping on about can be a win / win result. This also assumes that the child can either pay you out (such as by refinancing) or is willing to sell when you need your retirement dollars. It’s also possible to sell in stages to make this more affordable, which might also save you some tax dollars by staggering any capital gains over multiple years rather than having it all taxed in a single year. Ultimately, this strategy is essentially investing with your child rather than with your stockbroker to fund your retirement. The key is ensuring that you’ll be able access your capital when you need it.

When co-owning property with a child, here are some suggestions when looking at a written agreement:

Don’t try to do it alone. Get a lawyer involved and ensure that any agreement either says the others got independent legal advice or were advised to do so.

Have your child’s spouse be a party to the co-ownership agreement. This offers greater protection if your child dies or divorces. Although you don’t need to enforce every part of the agreement in every situation, why not have that option?

Clarify who is responsible for ongoing costs related to the property or how they are to be apportioned. This is particularly important if there is a mortgage or if renovations are likely in the possible.

Particularly if you’ve paid most or all of the purchase price and the child is covering all of the mortgage, determine how the equity is to be divided when the time comes. For example, do you get your down payment back and your kid gets any amount paid towards the mortgage back before the rest of the equity is divided?

Include provisions for when you can compel the sale of any property if the kid can’t or won’t buy you out, such as at your retirement or various deaths or any time you want with a set amount of advance warning.

Consider adding restrictions on using the home as collateral without approval of the other parties.

Require mandatory mediation and binding arbitration instead of court if there is a problem with the agreement. This may be particularly useful if something happens to your child and you have to deal with that unreasonable son or daughter-in-law.

Consider if any of the parties want to have life insurance on the others to pay for a buyout on the key person’s death.

If you want the child to receive any remaining equity on your death as part of their inheritance, clarify how the place is to be valued, particularly if that child might also be your executor, in order to avoid any conflict-of-interest worries. This might simply mean requiring a professional property appraiser paid for by your estate. Also, specify which costs should be paid by the child receiving the property should pay and which you want covered by your estate.

Final Words

Helping children own their own home can not only be a family affair, but also a shared dream. The goal is to prevent any generosity on your part from turning into a nightmare. Fortunately, there are several ways of protecting against things go wrong. Taking the time to carefully consider your options and to document your intentions can ultimately make all the difference.