Five ways to weather your way through your debt

Meteorologically managing your money

Credit is a great tool that helps us get established in life, but eventually our accumulated debt needs to be paid off. Easy enough said in principle, but for many people it’s tough to reverse the tap from accumulation to decumulation.

Most people come into debt slowly and steadily over many years. Expecting that it can be overcome quickly and effortlessly may not be realistic. You need to do three things:

    • Wean yourself away from taking on more debt
    • Make sure you are paying all the interest on what’s outstanding, and
    • Pay down the principal owed to your creditors
Where to start

With that in mind, here are some meteorologically-themed strategies to begin dealing with your debt. These are not mutually exclusive so decide what best fits your sensibilities, and keep in mind that planning is nice but you need to commit to action, even if it’s small steps.

Your first step is to figure out what you reasonably need to live on each month while you tackle the debt, which will then tell you how much is available to knock down the debt.

1. Steady soak – Even payments

The easiest arithmetic may be to just pay the same dollar amount to each debt, being sure that you’re above each creditor’s required minimum where extra interest or penalties may apply. Monitor it monthly (and otherwise don’t fret), and as the smaller items drop off, adjust the amount and reallocate among what’s remaining.

2. Sun showers – Smallest first

Actively tracking many accounts can be mentally wearisome, and even physically draining.  Instead, you could concentrate on your smallest debts one at a time, while paying the minimums on the rest. As you peel away those nuisance amounts, you build confidence in your abilities, freeing time and mental space to move on to the larger balances. As well, early and frequent victories will bolster your resolve.

3. Downpour – Biggest first

It depends on you, but one of the biggest stress inducers for many people is simply seeing a large dollar figure. Your heart sinks each time you open your statement because you see and feel what seems like an insurmountable obstacle. By wiping out large chunks of this large chunk, you’re able to see beyond it to get perspective on your entire financial picture, and make visible headway toward reaching your goals.

4. Thunder and lightning – Most costly first

If you ask the mathematical technicians, this is where you should begin. It can easily be shown that eliminating your highest interest debt is the fastest way to stem the flow required to service all of your debt. Once you’ve beaten down that most costly leakage, you can build on that momentum to aim at progressively easier targets. If you are driven by logic, this is the strategy with the strongest appeal.

5. All-weather solution – Your habits

Again, the key is to get started, but it could be a fruitless exercise in the long run if you don’t know how you got to this position. While you trim your debt, consciously consider your past and present spending patterns and living habits. This can free up more cash for the cause while in the midst of debt reduction, and lay the groundwork to be in a more comfortable position to enjoy and sustain sunnier days ahead.

Home … free? The principal residence exemption

Tax truth about the PRE

 The family home is a place of comfort and stability, and a significant store of wealth. And while there are upkeep costs involved, owners generally expect that they will benefit from rising real estate values.

But could that real estate growth be eroded by tax?

Fortunately, the principal residence exemption (PRE) is one of the most generous tax benefits we have, enhancing the appeal of home ownership by eliminating the tax on capital gains.

Qualification criteria
Type of housing

For the PRE, the property (including land up to one-half hectare) may be a detached or semi-detached house, townhouse, apartment, or part of a duplex or multi-plex; a condominium or share of a strata corporation; a share in a co-operative housing corporation; a vacation property like a cottage, cabin or chalet; a trailer, mobile home, or houseboat; and even a life lease arrangement or similar disposable leasehold interest.

It surprises many people to learn that the PRE applies not only to property in Canada, but also to foreign property that otherwise meets the criteria. Still, one must typically be a Canadian resident to make use of the PRE.

Ordinarily inhabited

To qualify as a principal residence, a property must be “ordinarily inhabited” in the year by the taxpayer, a current or former spouse or common-law partner (CLP), or a minor child. Note that in 1993 the term spouse was extended from married persons to include a common-law spouse of the opposite sex, and the latter term was further broadened in 2001 to include a person of the same sex under the new term common-law partner.

There is no minimum number of days that the property must be occupied in a year to qualify. Further, if more than one property is owned, the claim does not have to be made on the property that is more frequently inhabited.

If the main reason for owning the property is for income and/or capital appreciation, it will not be considered to be ordinarily inhabited. However, incidental rental income is acceptable, again as long as that is not the main purpose of owning. Even if the main reason is nonetheless to earn income, if it is rented to the owner’s child who lives there, then it may still qualify for the PRE. It is a question of fact whether a property is ordinarily inhabited, so legal advice should be obtained to clarify expectations if any of these factors are present.

Who may be the owner?

Whatever type of property it may be, the central condition is that it must be owned (that is, not rented) in order to claim the PRE. Usually the taxpayer must be the owner, though it may also be available in other ways:

Trust – If a person is a beneficiary of a personal trust, the trust may claim the PRE. The ordinarily inhabited requirement applies to that trust beneficiary, his/her current or former spouse/CLP or minor child.

Partnership – A partnership cannot claim the PRE, but a partner may use the PRE to offset a capital gain on qualifying property that is allocated from the partnership. Again, the ordinarily inhabited requirement must be met.

Corporation – While a corporation could own a property in which a shareholder resides, corporations cannot claim the PRE. Also be aware that if a shareholder makes personal use of corporate assets in this way, it will likely be treated as a taxable benefit based on how much it could have been rented to someone at arm’s length.

Calculating, reporting and claiming the exemption
From per-person to family unit

From 1971 when Canada began taxing capital gains, each person could claim the PRE, though it could only apply to one property for any taxation year. This allowed couples to multiply the PRE, for example by having one of them on title to the house and the other on a vacation property. In 1981, the rules changed to limit it to one property per family unit, generally meaning the individual, a spouse/CLP and their minor children.

When to make the PRE designation

A homeowner does not normally make the PRE designation from year to year. Rather, it is generally only reported in a year when there is a disposition. Dispositions include both actual transfers and deemed dispositions, with the latter including adding an owner to title, death of an owner, and a change in use such as converting a property to or from rental or business purpose.

Prior to 2016, a selling homeowner did not have to report anything if the entire gain could be claimed under the PRE. Now, it must be disclosed on the person’s income tax return for the year of disposition, specifically on Schedule 3 Capital Gains (or Losses). In addition, a Form T2091 must be filed, providing information including the address, acquisition date and cost, and the amount of the proceeds of disposition. Failure to file on-time could result in late penalties up to $8,000, or in the extreme a denial of the PRE.

How does the designation work

A taxpayer does not select specific calendar years for the PRE, but instead elects what proportion of years to apply it, using this formula:

The purpose of the “1 +” in the numerator is to accommodate for the common situation when there is a sale and purchase of property in the same year. This assures continuity such that the second property does not lose a year of claim, but does not confer any extra benefit as the PRE can only reduce the tax on a calculated gain to zero.

Provisos and pitfalls

Here are some more issues to discuss with a lawyer when buying, selling or considering a change in property use:

Legal and beneficial ownership – The PRE is based on beneficial ownership, which may not be the same as who is on title. It is the taxpayer’s onus to prove the nature of ownership if it is questioned. This is relevant in common law provinces, but under Quebec civil law, legal and beneficial ownership can’t be broken apart.

Renting a property – Despite the ordinarily inhabited rule, a property can be rented up to four years and still have those years qualify under the PRE, as long as a required tax election is filed. This may extend beyond four years if the reason for the property being rented is employment relocation of the taxpayer or spouse/CLP.

Former spouses – If the PRE is claimed by one party on a post-relationship disposition, the other party’s PRE entitlement will be limited or eliminated on his/her property if the two properties had been concurrently owned during the relationship. For certainty, a written separation agreement should address ongoing property dealings.

Elections for a deceased person – An executor may use Form T1255 to make the designation for a deceased person. If the deceased owned multiple properties, that designation could affect estate distribution if properties devolve to different beneficiaries. The testator’s Will could provide direction if there are any issues of this sort.

Robo-advisors: How medical symptom checkers can shine a light on them

The limits of expert systems

The long-running podcast Skeptics Guide to the Universe explores and de-bunks pseudo-scientific claims. One episode raised some flags with the way statistics are used to express the effectiveness of online medical symptom checkers. Though not directly transportable into the financial field, there were many interesting points raised that could help illuminate how we see automated financial advice – or as they are more commonly known, robo-advisors.

Co-host Steven Novella, a medical doctor, introduced the topic by questioning the accuracy of online symptom checkers (SCs). In a related blog post, he summarized the findings of an Australian study that evaluated the accuracy of 27 online SCs. Novella characterized the study’s results as “pretty disappointing.” On average, the correct diagnosis was listed first 36% of the time.

Not bad at first blush to hit it on the head more than one-third of the time, but the correct diagnosis was only listed among the top 10 possible diagnoses 58% of the time. For practical purposes, that means the correct diagnosis was missed 42% of the time, as most patients are unlikely to look beyond the top 10.

More interesting to me, though, were the potential reasons why the diagnoses were so poor.

Parallels with automated financial advice

Though the focus of the discussion was on medical-scientific matters, the observations could apply similarly to the automated tools in the personal finance and investment fields. These include do-it-yourself online brokerages and robo-advisors that offer online investment portfolios, but also advisors’ own tools: from the reference sources that clients never see, to side-by-side processes, to that solo interaction between the client and the evaluation tool.

Wherever the technology lies on that spectrum, it can’t be a proxy for the advisor.

As with the doctor-patient relationship, a financial advisor must understand the client in order to deliver personalized advice. The less the advisor interacts with the client, the more difficult it is to deliver.

And even with the benefit of direct contact, it remains the advisor’s responsibility to apply and explain the tools and their output, so the client’s interests are adequately served.

Points to ponder

Here are some of the podcast panelists’ thoughts on symptom checkers, and how they may apply to the delivery of financial advice:

Quality of input

Patients are often not very good at describing symptoms. People may say numbness when they mean weakness, or they may treat the two as the same, Novella said.

A client may use similarly imprecise language to describe their personal goals or their feelings about risk.

Alternatively, a client may adopt words offered by the document they’re filling out or the platform they’re using, without appreciating nuances. Absent the advisor probing further, the premises for a client’s action (or inaction) may not properly reflect their intentions.

People come to you with a narrative

Both medical patients and financial clients can be biased, frequently responding with their relative feelings anchored on recent experiences. One has to ask questions in multiple ways to deconstruct the objective facts from the narrative, and then reconstruct those facts in the medical or financial arena where they are to be applied.

It’s a dynamic investigative process that requires a lot of insight into how people think and communicate. A focused professional can then use this knowledge to move the relationship forward.

Body language

An experienced physician reads all the signs, including the patient’s body language. Advisors can observe a client’s posture and tone of voice, and how a couple interacts — things you don’t experience through checks in boxes or even the most eloquent text summaries.

Triage function

This is the “Do I go to the hospital?” moment. The SCs reviewed in the Australian study scored 49% on this measure, though they erred more on the side of sending people when it wasn’t necessary.

While there’s no life or death counterpart in financial advice, the accumulated harm of unverified guidance could make it difficult for someone’s finances to recover should problems materialize in later years.

The “why” of the output

It’s not enough to produce an output and expect that it will speak for itself. Newer SCs that use artificial intelligence give reasons for why they predict certain things, as well as how sure they are about the output provided.

That’s a large part of the financial advisor’s value to the client: explaining where things come from and where they are headed. It’s a check against the quality and thoroughness of the inputs that led to the output, and an opportunity to reinforce the client’s confidence and commitment to the plan you are creating together.

As a final point, it should be noted that SCs have no common regulation, if any at all. Comparatively, there is plenty of regulation in the financial field, and compliance departments help advisors stay vigilant and within boundaries.

Still, financial tools can be very complex. It’s incumbent on advisors to fully understand what is at their disposal so that digital platforms are used as tools of the advisor, and not in place of the advisor.