Last issue (April 19), I discussed how to manage capital gain on farmland if your family had the land before 1987, and how that is different for land you started farming after 1987, the year the rules changed. Today I want to discuss how to manage the money you get from selling your farm and how to create an almost permanent cash flow taxed at a lower rate than most income.
MANAGE TAX-FREE CAPITAL GAINS
Most active farmers are eligible to claim up to $750,000 of tax free capital gain when they sell farmland. If they manage their affairs correctly, so can their spouse.
Here’s an example. Let’s say you sell farmland. The first $1.5 million of capital gain could be tax free; you and your spouse may qualify for $750,000 each of capital gain or $375,000 each of tax-free capital gain. Capital gain is the difference between the sale price minus the legal fees, commissions and the original cost of the farmland or the value on January 1, 1972, if the family owned the land before that date. The taxable capital gain is listed on page one of your personal tax return but then subtracted on page of your return before the tax is calculated.
That is a lot of tax free dollars unless you still have debts to pay off. It is a little confusing so again it likely will pay to talk about this with your tax person. And as the article “Multiply your capital gains exemption” in the March 8 issue of Grainews explained, there are ways to qualify for more capital gain exemptions. But do talk to someone who knows this stuff.
I know I’m repeating myself but this is important. To qualify for the tax free capital gain all you need is for your parents or grandparents to have farmed the land before 1987. If they or you started to farm after that then you likely will need to farm the land to qualify for the exemption. One warning: if you quit actively farming before you sell the farm there is a chance you or your family could lose the tax free capital gain exemption. If there’s any danger of that, why not sell some land and use up as much of the tax free capital gain as you can while you are actively farming. It might be a use it or lose it sort of thing for some farmers. Or you could also actively farm the land along with a good farmer as I discussed in the last article and preserve the capital gain exemption for yourself and your spouse.
It pays to have your spouse listed on the titles of your farmland for two reasons. If you die, the farmland would automatically roll over to your spouse without any tax implications, and if you choose to sell the farmland she will likely qualify for the $750,000 exemption. It’s important for your spouse to file a farm tax return as well.
MAKE THE MONEY LAST
Sometime before you sell the farm or maybe shortly after, I strongly suggest you learn a new skill — selling covered calls on good stocks. This strategy can bring in much more cash flow than most people understand. Once you figure this strategy out, it’s quite easy to understand and do. And you can adjust the strategy to suit your time, your vacations and so on.
I teach this stuff in my newsletter StocksTalk all the time but you’re quite free to work with someone else who knows the strategy. Sadly, most people don’t understand selling covered calls so they call it risky, and I’m sure the cynics have talked many people out of a good cash flow. Me, I learned this stuff the hard way and it has paid me well during bear and bull markets. And I still travel, garden, fix cars, sleep and help a lot of people learn.
Let’s say you sold some farmland, managed the capital gain and now you have money to work with. If you want an above average return and cash flow then learning how to sell covered calls could easily be the strategy to earn income off some of your money.
After learning how to sell covered calls people should set up a Tax-Free Savings Account (TFSA). If you didn’t put $5000 into one in 2009, you can set one up now and put $10,000 into it for yourself and $10,000 for your spouse. Any gains earned on money held in a TFSA is tax free. That can be capital gain, interest, dividends, and income from selling covered calls. Be sure to ask to be approved to sell covered calls in the TFSA when you set up the accounts.
Many readers of StocksTalk have made 20 per cent or better in only part of 2009. From what I see they should be able to continue making 15 per cent to 25 per cent per year if they are prepared to work a little. If you want to see how much money the TFSA could make with just a 15 per cent return per year, take $5,000 x 1.15 = $5,750. After 10 years of this strategy the account could have $116,000 and still growing. If you can manage a 20 per cent return, after 10 years the account could have $180,000 in it working for you, and all the gains would be tax free.
If you don’t need the tax free cash this is still a great way to build wealth. If you do need the cash then at 15 per cent gains after six years the account could be earning you $5,000 per year tax free so some investors might choose to stop adding more money to the account. At 20 per cent return after four years the account could be earning $5,000 per year.
I know this sounds almost too good to be true, yet many readers of StocksTalk who had little experience with stocks have made that kind of money in 2009, and I believe they can keep on making above average returns with this strategy.
TRADING ACCOUNTS AND TERM DEPOSITS
To add balance to your portfolio, I would put some comfortable amount but less than half of the money from selling your farmland into a trading account for stocks that pay a dividend. I would put the other chunk of money into safe term deposits. My reasoning goes something like this: first of all, if you manage the half in stocks reasonably well, the money from selling covered calls, dividends and some capital gain could easily make you 12 per cent to 25 per cent per year. If you’re working with $200,000 or $300,000 at any reasonable return this strategy could make you between $24,00 to $30,000 to over $50,000 per year. Add in some interest income from the other half of the money, plus OAS if you’re old enough and some CPP and rent from farmland and odds are you could easily be making more money when you’re retired than you ever made farming or working at a job. And since this is quite an easy strategy we could call this permanent cash flow.
If you’re new to stocks then you can buy what we call comfort stocks. They usually don’t go up and down much but over time they usually go up in price. They also pay a decent dividend and most raise the dividend regularly. I worked out returns from a comfort stock like Fortis and it seems to be quite easy to make 12 per cent to 15 per cent per year from dividends, selling some calls and some capital gain. There are other comfort stocks.
Some investors like capital gain from their stocks partly because they’ve been trained to think that way and partly because it takes very little work. I like cash flow because it is spendable money, but it does take some work. Take your pick.
Plus you’d still have some farmland that could be going up in price as the years go by, and half of the money from land you sold would be tucked away safe but not earning you much money.
The bond market is moving into a time of troubles. The Bank of Canada has made repeated suggestions that as of the beginning of the third quarter this year, it will begin to raise interest rates. Existing bonds will drop in value as they are replaced by newer bonds that deliver higher interest. It won’t be a good time to hold a lot of bonds, especially long bonds that are highly responsive to interest rate changes.
The phenomenon of rising interest rates is observable in many markets around the world. Recovery in financial markets, the return of inflation and rising chances of default in government bonds in Portugal, Ireland, Italy, Greece and Spain (the so-called PIIGS) implies that investors will have to get more interest to cover their risks.
Those risks are very real. In the bond market, one can buy insurance against defaults. Called Credit Default Swaps (CDS for short), these contracts, which are priced for each issuer, cost about 3.6 per cent of the face value of Greek bonds and are now pricing in defaults by American states. The idea of a default by a western European country or a major U. S. state used to be too odd to contemplate. Now you can get a bid off a Bloomberg screen in a moment.
The largest single risk to all holders of conventional bonds is inflation. According to data from Scotiabank’s economics department, consumer prices are gong to rise 1.8 per cent in 2010 and 2.2 per cent in 2011. In the U. S., consumer prices are due to rise 3.6 per cent in 2010 and 2.6 per cent in 2011.
Inflation rates could rise even faster in the U. S. And where America goes, Canada eventually follows. Our central banks work in much the same way and it is unlikely that Canada could have a low interest rate policy while the U. S. was forced to pursue a high interest rate policy. The U. S. currency would soar, ours would sink, and we’d get a lot of inflation as a result. That would force up our interest rates and the rate disparity would close.
The U. S. is going to face much higher government borrowing costs to finance the first year of enhanced national medical and hospital insurance. Recent estimates suggest that the U. S. will have to add US$1 trillion to its spending and borrowing to pay for the medical insurance obligations it is taking on.
Medical care will also be inflationary. Health care already accounts for 13 per cent of U. S. Gross Domestic Product. Estimates suggest it will rise to 17 per cent with the aging population, which requires more medical services. Add in the pressure on the health system produced by 30 million Americans with instant access to health care services they have been denied and one can see health service providers raising the prices. That, in turn, will raise government spending requirements.
Taxes are also going to rise in the U. S. to pay for enhanced health care. In theory, if more money goes to government, there is less left for consumer spending, but that is not necessarily going to suppress consumer spending. The huge flow of money into health services will have a multiplier effect. The doctors and nurses, bandage and pill makers will spend their money, pushing up the prices of things from fancy cars to bedspreads. The effect of more government spending will thus be inflationary, though to what extent it is hard to predict.
Canada imports much of its goods from the U. S. So Canadian prices for groceries and tractors, shirts and furniture are also going to get a boost. We will see the effect in higher price tags. And in inflation rates too.
Higher inflation rates and rising potential default rates in many countries will make bond investing a much tougher game in the next few years. The old, easy method of buying some government bonds or AAA or AA corporate bonds isn’t going to work very well. Those will be the bonds that will be most susceptible to price erosion from rising interest rates. Lower investment grade corporate bonds with single A or BBB ratings may do better as their individual companies’ earnings or balance sheets improve, but shopping this market takes considerable research skill. These bonds are hard to get as well.
SHOPPING FOR BONDS AND SUBSTITUTES
Bond fund managers can shop for bargains, but the problem with a bond fund is that it never reverts to cash as a real bond does. It can generate and sustain losses for many years. In a climate of rising interest rates and inflation rates, only inflation tracking Canadian real return bonds and American Treasury Inflation Protected Securities are likely to do well. If you buy either of these, hold them in an RRSP or a TFSA. Otherwise, annual taxes on their rising prices, which our government chooses to tax as income, will be costly.
One alternative to buying conventional corporate and government bonds is to buy high quality preferred stocks. By one way of thinking, preferred stocks are just deeply subordinated bonds that don’t even have a contractual guarantee of payment of dividends. That is true. But a preferred from a chartered bank with a term date of a few years or a bank rate reset bond that adjusts interest rates every few years to the five year Government of Canada bond plus a few percent is not a bad deal. You get the dividend tax credit as well, pushing up the tax-equivalent value of the dividend by about 29 per cent in high tax brackets.
The final alternative is to sell your long bonds — the ones the will be most hurt by rising interest rates — and use the money to buy solid common stock with a history of rising dividends. Many companies qualify — the big chartered banks, Great-West Lifeco, Power Corp., Power Financial, EnCana Corp. and Rogers Communications pay dependable dividends and have raised them for five or more years. You can get three to five per cent annual dividends from these shares and a high probability of dividend growth. These shares will fluctuate with the market, of course, but over the long term, they should return both decent dividends and price appreciation.
Of course, one may object that the stock market isn’t going to keep rising forever and that the recovery from the 2008-09 recession is incomplete. Putting money into stocks, which are overvalued by some analyses, is thus even riskier than buying bonds which, of course, promise to return their face value one day.
That caution is correct. Yet one may also argue that the fates are running in Canada’s favour right now. Europe’s troubles are driving cash into the U. S. bond market and supporting the greenback. A lot of other money is pouring into Canada’s banks, insurance companies and mutual fund management companies. The loonie is now one of the world’s most solid currencies. It may take years for European countries to fix their balance sheets and, in that space, the present trend of support for Canada’s capital markets should continue. Add in the fact that Canada’s government finances are in far better shape than those of the U. S. and you have an argument in favour of buying Canadian stocks and bonds — all selectively, of course.
The problem with trying to cherry pick the best stocks and bonds is that the professionals will beat you to them. Your best bet is to use exchange traded funds (ETFs) with low management fees to buy stocks and bonds with short to medium terms. ETFs replicate many bond portfolios, many stock indices, especially the biggest 60 stocks on the Toronto Stock Exchange. You can get a ladder of government or corporate Canadian bonds due in one to five years packaged in an ETF. All have management fees far lower than most mutual funds offer. The ETF route can provide short bonds and dividend growth stocks with very low management fees. An investment advisor can help select them from the many thousands that are available.
The point is clear — buying bonds as a bet on falling interest rates is a game that has ended. The wise investor will seek another model of investing. Be creative, but be prudent. Bringing conservative bond selection criteria to the wilder game of picking stocks should create a good foundation for gains.
Andrew Allentuck is author of Bonds for Canadians: How to Build Wealth and Lower Risk in Your Portfolio, published in 2006 by John Wiley & Sons Canada Ltd.