(For more explanation on how a MIC works and the general application of a MIC in a balanced portfolio, please see my column available exclusively in the print and digital editions of MoneySense magazine.)

Of course market veterans are quick to point out that with great reward comes great risk. Considering the stagnant stalwarts of fixed income—GICs and government bonds—are struggling to offer investors a rate of return of at least 1.5%, wouldn’t that put MICs in the great risk category? Not when you consider the underlying assets. Because MICs must keep 50% of their holdings in mortgages backed by residential real property (or in CDIC-insured holdings), the majority of risk revolves around residential mortgage default rate—a rate that is notoriously low in Canada.

“Even in the 1990s, when the Canadian real estate market crashed, the default rate for residential mortgages never climbed higher than 0.66%,” explains Jane Knop, the Harvard-educated managing director for First Swiss AM, a Toronto-based MIC that specializes in residential first and second mortgages. Compare this to the average default rate of North American corporate bonds—which sits at 1.01% between 1982 and 2010.

Examime the risks

With apparently lower risk and higher returns, does this mean you should liquidate your fixed income holdings and plow the money into MICs? Not necessarily.

The truth is not all MICs are created equal. While all are legally mandated to keep 50% of their investments in residential mortgages, what constitutes as a residential mortgage can be quite broad—and this can seriously impact the level of risk and volatility of a MIC’s investment portfolio.

For instance, residential debt can include first and second mortgages. If you hold a first mortgage you have priority if a default occurs. This makes second mortgages more profitable, but much riskier.

Residential debt can also include construction loans or bridge financing for residential new-builds or repairs—a much riskier form of debt given its commercial nature. (Although, the debt is still considered residential under the Income Tax Act.)

Other risk factors include:

• A high loan to value on any one property;
• Whether or not the MIC is too geographically concentrated. For instance, if all loans are in Northern Alberta, these loans could be seriously impeded if oil commodity prices drop and homeowners are left unemployed and forced into foreclosure;
• If a MIC is highly leveraged this may be a bad sign. That doesn’t mean MICs with lines of credit or that use leverage are poor investment choices. In fact, a MIC that doesn’t have access to a line of credit or excess capital can actually be worse, but you don’t want to invest in a MIC that’s boosting their returns through leverage. The returns should come from their portfolio of holdings, and the leverage used to establish solid holdings for long-term performance;
• Whether or not the MIC has policies limiting the maximum percentage or total dollar amount that can be invested in any one mortgage or borrower.

Evaluating those risks

“It’s about due diligence,” explains D.G. Southen—a London, Ont.-based real estate investor who started with bricks and mortar holdings and added MICs to his portfolio just over two decades ago.

But just like buying a corporate bond or a sector ETF or mutual fund, the more you know about the underlying asset, the better you can asses the level of risk associated with the investment. When evaluating a MIC, make sure you examine the underlying portfolio of debts. This analysis should include:

• A list of addresses where mortgages are held;
• The property values and their loan values on each address (or sector, at the very least);
• And the purpose of the loan—is it for construction, will it be used as a bridge loan, is it to establish future income-producing cash flow. Also, verify whether the mortgages are first or second mortgages. While you’ll get the opportunity of a greater return on a second mortgage, you’re also adding much more risk.

You should also ask to see independently audited financial statements as well as the MIC’s dividend statement—the annualized net returns offered by the MIC since inception.

In the end, though, what you’re really buying is the manager’s performance, says Michael Nisker, managing partner of Trez Capital, a firm that offers only a handful of publicly-traded MICs on the TSX. “In that respect, you need to answer two questions: What is their record? And how long does that record continue?” Consistent returns—not one year high and the next low—with a close to zero loan loss for a decade or more shows a well-run book of business.

It was this due diligence that enabled Southen to earn a 12% annualized rate of return over the last 22 years. “I have not held a common share in my RRSP since 1991,” says Southen. “The reason? I make more money with debt investments than I ever would with common shares.”

Keeping it tax efficient

For those interested in MICs, be aware that you don’t make money on the appreciation of the shares you own. Instead, you earn a dividend-like payout every month (or quarter or year) based on the interest collected from the pool of mortgages owned by the MIC. The more shares you own the larger the payout, which is taxed at your top tax rate as interest income.

To minimize the taxes you pay look for corporations that offer holdings in registered savings plans, such as an RRSP, TFSA, RRIF, RESP, RDSP, among others.

To keep your MIC holdings in a registered plan you’ll need to pay the corporation administration fees, and some are definitely more economical than others. Typical costs for an RRSP holding range between $100 to $150 per year, while an RESP or a TFSA holding will cost you $25 to $75 per year in administrative fees.

Also, keep an eye out for set-up, closing and redemption fees—you’ll want to know these up-front so you can factor in these costs for entering and exiting the investment.

Will you get double-digit returns?

Finally, don’t be surprised if MIC returns have—or continue—to drop. At present, most stable MICs are providing a net 5% to 10% return to their investors, depending on the risk level. “There’s more capital competing for the good, quality debts and that pushes rates down,” which impacts returns, explains Knop. This may change as more individuals and businesses find it difficult to qualify for mortgages, but for now, even MIC returns are feeling the pinch. That is if you consider a 5% to 10% annual return on a fixed income investment pinched.

Where to find a MIC

Finally, if you’re really interested in MICs you’ll need to do a bit of your own research. For those interested in private placement MICs—corporations that sell shares through Offering Memorandum, you’ll need to do a search. There are hundreds of MICs in Canada—some large and some small. For accredited investors, there is ample choice and MICs can be found operating in almost every province, but you’ll need to really examine the investor materials provided. Remember you’re looking for consistency, longevity and a lower risk profile for sustained returns.

For non-accredited investors, or investors with a lower minimum sum to invest, consider publicly-traded MICs. Up until 2011 you really had only three options to choose from. However in the last year, the number of publicly-traded MICs on the TSX has risen to about a dozen. The advantages of these market-traded MICs are as follows:

• No minimum investment or accredited investor requirements;
• Better liquidity;
• Potentially better disclosure by virtue of it being a listed, public company;

Current list of publicly-traded MICs (in alphabetical order):

Atrium Mortgage Investment Corp. (TSX: AI)

Mandate: One or two year terms with 85% first mortgages an 15% second mortgages on income-producing residential real estate, with 65% in residential and 35% in commercial residential.

Weighted average loan-to-value of mortgage portfolio is 66.7%

Current Yield: 7.35%

Distributions: Monthly

Fees: Not apparent

Eclipse Residential Mortgage Investment Corp. (TSX: ERM)

Mandate: Single family residential mortgages

Current Yield: 6% to commence after anticipated closing date of June 28, 2013

Distributions: Monthly

Fees: Not apparent

Firm Capital Mortgage Investment Corp. (TSX: FC)

Mandate: Mostly conventional first mortgages in Ontario

Current Yield: 7.64%

Distributions: Monthly

Fees: Management fee of 0.75%; mortgage banker fee of 0.1%; performance fees charged on mezzanine and equity investments

First National Mortgage Investment Fund (TSX: FNM.UN)

Mandate: Single-family residential mortgages and multi-unit residential and commercial mortgages across Canada

Current Yield: 6.56%

Distributions: Monthly

Fees: Management fee of 1.35%; performance fee of 0.20% over hurdle rate (hurdle rate based on 2-year GOC bond yield plus 4%)

MCAN Mortgage Corp. (TSX: MKP)

Mandate: Uninsured single-family mortgages and residential construction loans with core markets in Alberta, Ontario and B.C.

Current Yield: 6.86% ($1.42/share)

Distributions: Quarterly

Fees: $0.04/share

ROI Canadian High Income Mortgage Fund (TSX: RIH)

Mandate: Commercial mortgages

Current Yield: 6 %

Distributions: Monthly

Fees: Not apparent

ROI Canadian Mortgage Income Fund (TSX: RIL)

Mandate: Commercial mortgages

Current Yield: 5.04%

Distributions: Monthly

Fees: Not apparent

ROI Canadian Real Estate Fund (TSX: RIR)

Mandate: Commercial mortgages

Current Yield: 6%

Distributions: Monthly

Fees: Not apparent

Timbercreek Mortgage Investment Corp. (TSX: TMC)

Mandate: Primarily residential and retail mortgages in Ontario, Alberta and Quebec. No leverage

Current Yield: 7.79%

Distributions: Monthly

Fees: Management fee of 1.2% per year

Hurdle rate: 2-year Government of Canada Bond Yield plus 4.5%

Timbercreek Senior Mortgage Investment Corp.(TSX: MTG)

Mandate: Shorter-term first mortgages (or customized first mortgages) in residential and multi-residential, as well as office, retail and industrial properties located in large urban markets

Current Yield: 6%

Distributions: Monthly

Fees: Management fee of 1.0%

Hurdle rate: 2-year Government of Canada Bond Yield plus 3.5%

TREZ Capital Senior Mortgage Investment Corp.(TSX: TZS)

Mandate: 50% in residential and the remainder in office and retail mortgages. Loan terms up to 36 months with a concentration in Ontario, Alberta and B.C. (but some holdings in Saskatchewan and Nova Scotia)

Current Yield: 5.0%

Distributions: Monthly

Fees: Not apparent.

Hurdle rate: 5% over GOC bonds

TREZ Capital Mortgage Investment Corp. (TSX: TZZ)

Mandate: 50% in residential, 40% in office and remainder in industrial and retail. Loan terms up to 36 months with a concentration in Alberta and Ontario, but with holdings in New Brunswick, Nova Scotia, Quebec, B.C. and Saskatchewan

Current Yield: 7% to 9%

Distributions: Monthly

Fees: Not apparent.

Hurdle rate: 5% over GOC bonds

What drives up the value of a timeshare?

Like any commodity, timeshares have a value. Not just in the resale market, but also as a method of exchange, where owners can exchange their timeshare week for another week at a different resort.

To get the most out of your exchange you’ll need to understand what factors drive up a timeshare’s value.

Location. Like in all real estate, location really is the most important feature in a timeshare. Buy in the right location and you will never have trouble renting or exchanging the unit. To find the right location you’ll need to examine the supply of timeshares in each of the destinations that are on your family’s “wish list.” Locations with high demand and limited supply will have a higher value.

At the moment the areas that meet these criteria include: Hawaii, San Francisco, parts of coastal California and a few of the big U.S. ski resorts in the. Internationally, popular areas include Paris and London.

Areas that are overbuilt (which lowers the value of the timeshare) include: Orlando, Las Vegas and Whistler.

While general locale will impact a timeshare’s value, so will the specific location of a timeshare resort. For instance, a beachfront unit will almost always be in higher demand than a unit five or six blocks inland.

Unit size. Unit size refers to square footage, but the key to good value is the number of bedrooms a unit offers. As a general rule of thumb, a two-bedroom unit will always have a higher value than a one-bedroom or studio unit. But the unit size will always be trumped by resort location. This means a one-bedroom beachfront unit will command more in rent or have a higher exchange value than a two-bedroom unit a few blocks away from the beach.

Season. In the timeshare world, seasons are often colour coded, with different colours corresponding to different seasons. The rationale is that certain seasons have a much higher value than other seasons. Even different weeks within the same season will have a higher value than other weeks.

Be forewarned: You cannot compare different colour designations for different resorts when looking at exchange value. When in doubt, find out how the resort codes their seasons, and trade (or buy) based on value, not colour.

Advance deposit. If you’re interested in exchanging your timeshare, you’ll want to pay attention to the rules and regulations around depositing weeks. Many vacationers will actually make their timeshare plans 12 to 24 months in advance and, according to one timeshare vacation club, a timeshare actually starts to devalue when there is less than a year left before the date of use. That means, the less time your timeshare is on the exchange market the less value it holds. To get maximum value you’ll want the earliest possible exchange options.

Resort rating. While many owners are happy to hear that their timeshare is a five star or a Gold Crown resort, these ratings do little to increase the value of your timeshare. That’s because these ratings are based on the amenities provided at the resort, not the demand for the resort. For example, a beach front resort with a low or no amenity rating will often have a higher exchange value than a top-rated resort located a short distance inland. Only if two resorts are located in similar settings will resort ratings and amenities impact the exchange value of the timeshare.

How do exchanges work?

There are three ways to exchange your timeshare: through owner-to-owner exchanges (known as direct exchanges); exchanges within a resort group that provides this as part of their timeshare membership; and exchanges through third-party companies that specialize in renting and exchanging timeshare weeks.

Direct exchange. A direct exchange can be the simplest and most straight forward way of exchanging your timeshare. If, for instance, you owned a timeshare in Hawaii but wanted to go skiing in Whistler, all you need to do is find a Whistler timeshare owner that wanted to make a straight exchange. You’d end up in Whistler and the other owner would end up in Hawaii.

The one drawback with direct exchanges is finding and contacting other owners to make an exchange. There are websites that cater to this type of exchange, such as Tug2.net’s exchange marketplace. Another option is to contact the management at the resort you want to visit and ask if there are ways to contact their timeshare owners directly.

Once you’ve made an agreement to exchange, each owner must contact their respective resorts to notify them you’re reassigning your right of use to another owner.

To be successful with direct exchanges, you’ll need to be comfortable with long-range vacation planning, usually starting the process 24 months or longer from week of use.

Exchanges within a resort group. Many timeshare programs include multiple resorts in different locations. This lets owners take advantage of different vacation spots. You select the week you’d like at a sister-resort in accordance with your club’s rules. In some cases these exchanges are free, while other clubs will charge an exchange fee.

Exchanges through an exchange company. The advantage of using an exchange company is there is a larger pool of fellow timeshare owners also looking to exchange weeks. To use an exchange company you will be required to “deposit” your week into their “spacebank.” As soon as you deposit a week you have the right to obtain a different week from the company’s spacebank inventory.

The two largest exchange companies are Resort Condominiums International (RCI) and Interval International (II), but there are other smaller, independent vacation clubs in the timeshare marketplace. However, most timeshare resorts have a formal affiliation arrangement with either RCI, or II, or both.

Most exchange companies will charge a fee for each exchange. RCI and II also charge an additional annual membership fee, in addition to the per exchange fee.

There are also different procedures governing timeshare deposits, depending on the type of timeshare you bought. For instance, you can simply deposit a fixed week timeshare with any exchange company. If, however, you bought a floating week you will need to contact your own resort to have a week assigned to you before you can make a deposit into a spacebank.

One industry practice that can complicate your own exchange is a resort’s decision to “bulk spacebank.” This is when a resort deposits a large number of unassigned units with an exchange company even before owners have the option to spacebank their units. If this happens, contact your resort to explain that you intend to deposit a week for exchange. They should then contact the exchange company and ask for one of the deposited bulk weeks to be transferred to your account.

If you deposit a week and then change your mind you can usually get the week back but only if the week is still available and only if you have not selected another exchange week in lieu of your deposit.

For an in-depth discussion on exchange procedures please see Tug2.net’s Timesharing 101.

Estimated cost of a timeshare

By now, I’m sure you realize that a timeshare purchase is about spending disposable income; it’s not an investment. If you do make money on the resale of your timeshare consider it a bonus, just don’t expect it.

At this point you know enough about timeshares to begin an analysis on whether a specific timeshare makes sense for you. To do this, we need to factor in all the costs of owning a timeshare. Before we proceed, though, we need to keep in mind that when you buy a timeshare you are actually tying up your money—this is known as an opportunity cost. If you were to spend $10,000 on a purchase of a timeshare, you lose the opportunity to invest this money. If you believe you could obtain a 5% annual return if you invested the money, then the opportunity cost for the timeshare would be $500 per year. Many timeshare owners leave this cost out of their analysis, but as savvy savers and investors, we’re going to include this in our analysis of timeshare ownership.

To determine a timeshare’s valuation, consider the following purchase example:
• One-time purchase price: $2,000
• One-time transfer fees and closing costs: $575
• Annual maintenance fees: $600
• Annual exchange company membership: $100
• Biannual unit exchange every other year with exchange company: $120
• Annual opportunity cost: $100

Based on these numbers you’re costs of ownership are as follows:
1. One-time costs: $2,575 (if you use the timeshare over five years, this is an amortized cost of $515)
2. Annual costs: $860
3. Total annual costs including amortized one-time costs: $1,375

To decide whether the timeshare is a wise purchase simply compare the cost of a rental for a similar type of unit in the same location or resort. If the rental costs are higher, then it makes more sense for you to purchase the timeshare (as long as your lifestyle suited this vacation option). If rental costs are cheaper than consider buying a timeshare in another location.

If you use these calculations every time you consider a timeshare purchase, you’ll not only be able to find your top price—the highest price you should pay before renting becomes a more sensible option—but you’ll make an informed decision based on value.

What not to buy

The easiest way to avoid a timeshare dud is to follow the advice that was given to me: never buy a timeshare you don’t really want in the hope you can exchange it.

The key to getting the maximum value out of a timeshare, says one veteran, is to buy what you’ll use, when you need it. That way you’ll still use the timeshare vacation even if you can’t exchange the week for another vacation option.

Another rule of thumb is to avoid off-season weeks. “You’ll end up giving away an off-season timeshare, just to get rid of it,” says DG Southen, an experienced real estate investor from London, Ont. Instead, become familiar with the busy times for every resort and buy a week that’s in demand. You’ll pay more upfront, but you’ll also have an easier time off-loading it on the resale market, or renting it out to other vacationers, or exchanging it in the timeshare marketplace.

What you can buy

Before buying a car, you would first decide what type of car you needed. The same applies to a timeshare.

While a timeshare is ownership and/or use of real estate for specific periods of time you do have four different options as to how to purchase this vacation time.

1. Fixed week. Buying a fixed week timeshare ensures that you have occupancy rights for the same week and usually the same unit year after year. This is based on the timeshare calendar, which counts weeks based on the initial check-in day, which is usually a Saturday. For instance, if you purchased a timeshare for unit 122 for the 23^rd week, then you would have a guaranteed occupancy for that unit on the 23^rd Saturday of each calendar year. The attraction to a fixed week is that there is a level of certainty as to when you can use your timeshare vacation. The drawback is the resale value can often be lower than timeshares with floating weeks, which offer a bit more flexibility. (Fixed week calendar sample for 2012-2013).
2. Floating week. Also known as a flex week, this timeshare gives you the right to use a unit during a specified period. The catch is you must contact the resort to reserve a specific week during your floating period. While this type of timeshare gives you more flexibility it also means you can’t delay in reserving a week, as you are competing with all the other timeshare owners that share your floating block of time. Each resort will set their own policies on how far in advance owners can reserve floating weeks, with some resorts opening up the spots only nine months in advance, while others allow for reservations two years before your check-in date.
3. Rotating week. If you purchase a timeshare on a rotating week then your usage week will change from year to year based on a fixed schedule. For example, if your timeshare is on a four week rotating basis, then your first year usage might be for week four, second year usage will be for week 18, third year usage would be for week 36 and your fourth year of usage would be for week 48. In year five, the cycle would start again and repeat. Timeshare properties with rotating weeks allow owners an opportunity to use the resort during every season, ensuring that everyone gets a chance to visit the resort during the most popular seasons.
4. Points system membership. A vacation club membership doesn’t offer ownership rights. Instead it provides its members with a currency—points—which may be used to purchase various vacation options. The idea is to provide members with one-stop shopping for their vacation needs. Because of this, these memberships are often more flexible then other timeshare types. However, a point system will also require you to research and reserve your vacation well in advance, especially for high demand periods. Some resort systems allow vacation owners to reserve 13 months in advance, while others require 10 months before reservation date.

It should be noted that point systems have had problems because of bookings. This has led to legal actions against various membership clubs (see the blog about class action suits brought against various timeshare companies).

Despite these problems, vacation clubs remain popular within the timeshare community. To understand how points work, let’s assume that a two-bedroom in Florida costs 140,000 points each week (about 18,000 point for weeknight stay and 25,000 point for each weekend night). If you owned 280,000 points you could book two weeks at the two-bedroom, or you could opt to book a one-bedroom (at a cost of 100,000 points for the week) and spend the rest of your points at a nearby theme park or on a guided expedition.

Most point systems will require you to use your points within the year they are earned, or you will lose them. Another option is to deposit your points into an exchange company, which will charge their own fees for use. The key is to read the fine print and calculate what your costs will be for using this type of timeshare.

Get to know the lingo

Once you understand the type of timeshare you’re interested in buying, you’ll need to become familiar with timeshare lingo so you can start to decipher what’s being sold in the resale market.  Here’s a sample of a few of the more pertinent terms:

Accrued weeks: Any unused weeks from the previous year that have been banked and are available for use in the current year. This option is not always available so double check before you buy if this is an important feature for you.

Anniversary date: This applies to timeshare vacation clubs and refers to the day earned points accumulate in your account.

Banking: The ability to store unused weeks, or points, to be used later.

Every-other-year (EOY) or Biennial: A timeshare that allows you to buy the deed or right-of-use for every second year. This also means your maintenance fees will be biennial.

Fixed unit: Where the owner has the rights to the same physical unit every year.

Fixed week: Where an owner as the right to use a specific week during the calendar year (usually identified by a number, such as #34 denotes use of a unit for a week starting on the 34^th Saturday in a calendar year).

Floating week: This week may be used by the owner at any time during the calendar year or during the season that was bought based on the resort’s availability.

Levy: Administrative fees charged to point system members by the resort for use of a particular week.

Lockout unit: A lockout or lock-off is a unit that can be divided into two or more separate sections. For example, a lockout unit could be used as a two-bedroom or it could be split into a hotel unit and a one-bedroom unit.

Quartershare: Three-month interval ownership with a rotating schedule.

Red week: Refers to the peak season at a resort during which timeshare properties are at their most desirable.

Season: Seasons are typically blocks of time throughout a calendar year that express the value of a period of use. For example:

At RCI:

• Red = High
• White = Mid
• Blue = Low

At Interval International:

• Red = High
• Yellow = Mid
• Green = Low

Space banking: When an owner deposits a timeshare week into an exchange company’s “bank” (inventory) in order to trade for another week/resort.

Week 53: This week is reserved for the exclusive use of a resort developer.

For a more comprehensive timeshare glossary please see SellmyTimesharenow.com.

Part 3: Determining value

Often, it’s these encounters—followed by less than desirable vacation experiences— that give timeshare ownership such a horrible reputation. But the reputation is unwarranted. In fact, a timeshare can be an excellent budget option for vacations, as long as you do your homework.

“Nothing matches the value of a timeshare,” says DG Southen, an experienced real estate investor from London, Ont. For the last decade Southen has bought, sold and used timeshares. Southen, and thousands like him, has found ways to make timeshares work as cost effective vacation options.

In the current issue of MoneySense magazine (“Own A Piece of Paradise,” June 2013), I touch on the effective use of timeshares, but I want to expand on my coverage. Partly because timeshares are a misrepresented vacation option, and partly to help those interested in purchasing timeshares to make more informed decisions.

What, exactly, is a timeshare?

The idea behind a timeshare is relatively simple. It’s an agreement where you share the costs and use of a home, cabin or condo with other people. When you buy a timeshare you are buying the right to use these shared facilities and paying the costs for such rights.

Unlike hotel rooms, and much like resorts, timeshare units offer more than just a place to sleep. Typically they come with full kitchens, are completely furnished, have quick access to indoor and outdoor pools, as well as other resort amenities, such as restaurants, night clubs and even babysitting services.

How do timeshares work?

There are three basic types of timeshares: right-to-use, fee simple, and a point system or vacation club timeshare. The rules are different for each one—and this can dramatically impact the price and resale value of the timeshare (along with other factors that I’ll get into later).

Right-to-use timeshares are contracts to lease a property, usually for one or two weeks each year, over a set period of time. During this time you are responsible for all maintenance fees and any special assessment fees, should they arise. (Like a condo, timeshare resorts must maintain a property. At times significant repairs are required and to pay for these repairs, the resort will levy a one-time special assessment fee that is shared by all owners of the timeshare resort.) At any time you can rent, give away, or sell your right-to-use ownership of the timeshare.

A fee-simple timeshare, also known as a deeded timeshare, is essentially like buying the property for a specific period of time each year. You will be responsible for the purchase price, as well as annual maintenance fees or special assessment fees, should they arise. You may also need to pay property taxes or other fees although many timeshares now roll these costs into their annual maintenance fees.

Timeshare point systems or vacation clubs allows you to buy points within a resort network. You can then use these points to “purchase” the vacations available within the specific network. The benefit of a point system is that it doesn’t lock you in to a specific property and time each year. Instead these points give you access to multiple properties worldwide and some even allow you to purchase flights, cruises or other types of vacations offered within the system.

What will my timeshare actually cost (resale vs. retail)?

According to industry statistics, 50% to 70% of a timeshare’s retail price—the price you pay at the resort after listening to a timeshare sales presentation—goes towards marketing. For instance, if, during one of those presentations, you purchased a timeshare for $20,000 as soon as you walked out of the room, the value of that timeshare would drop to between $6,000 and $10,000, if that.

The easiest way to save money, then, is to buy resale not retail. This is how Southen has kept his vacation costs down and his timeshare value up. There are a number of websites that offer resale timeshares, such as Ebay, Tug2.net and Redweek.com.

Next, you’ll need to calculate one-time costs and ongoing fees associated with timeshare ownership. For instance, just to finish the transfer transaction you’ll pay between $300 and $500 in closing legal costs, plus another $50 to $300 to the resort. Factor in the annual maintenance fee—fees that cover the operation of the timeshare resort—fees you must pay even if you don’t end up using your timeshare. These fees range from $300 to $2,000 (or more) per year depending on the resort, destination and luxury level you’ve bought into.

You should also be aware of special assessments. Southen went through this with a timeshare he owned in Whistler, B.C. The resort required additional structural repairs and, like a condo, each timeshare owner had to foot the bill. Southen got off lucky. He, and all the other owners, only had to pay $1,000 each to cover the repairs, but it could’ve been worse. To avoid these unexpected costs call the resort property manager and ask when the last assessment took place and when the next one is scheduled to take place. If the resort waits too long between assessments—more than five years—then, you as an owner, may end up with a hefty one-time maintenance bill.

Where do I start my research?

Start with a pen and paper and make a list of all the amenities and destinations that would suit your family best, along with your ideal times for taking these vacations.
Then start checking the online auctions to see what prices your ideal choices are selling for in the current resale marketplace. “Don’t bid on anything, just watch,” advises Southen. “You won’t miss anything, because there’s always another good deal.”

At this time also watch and learn how specific auction sites work. For instance, sellers on Ebay can choose to end an auction early, and sell to the highest bidder, once they’ve achieved a set bid price. Other auction sites won’t allow “snipe” bids—bids made in the last minute or so. For instance, Redweek.com will add another 30 minutes to the clock for every “snipe” bid made within the last 10 minutes of the auction.

As you research you may find that some of your top choices are just too expensive for your budget. For example, a two-bedroom, ocean front villa in Myrtle Beach you have your eye on will start at $14,000. Despite the sticker price, any veteran timeshare owner will tell you this is an excellent deal—it’s a vacation area that’s always in demand and retains its value. But it may be a bit pricey for the budget conscious vacationer. Instead, you could pick up a great two-bedroom at the Sheraton Desert Oasis in Scottsdale, Arizona (which recently sold on Ebay for US$2,000), or a two-bedroom, ocean front, every-other-year timeshare at the Pahio Kauai Beach Villas in Hawaii (which recently sold on Ebay for US$1,300).

The key to getting a good deal is to watch the auctions, learn the system, and do your homework, says Southen. Then match what you’ve learned with what your family needs and wants and you won’t end up overpaying.

Part 2: Get to know the lingo

According to my accountant, this isn’t necessarily a problem. His rationale: If you owe tax it means you’ve made money. And capital gains are taxed at only half your marginal tax rate—one of the more favourable tax treatments offered by the CRA.

The real quandary, for most readers, is how to calculate this capital gains tax when the sale of the property is a tad more complicated than selling your principal home.

For that reason, I address some of the more interesting questions readers have sent regarding the sale of property and how to calculate the taxes owed on their capital gains.

(For more on the basics of the principal residence exemption and how the sale of property doesn’t always produce a capital gain see my Home Owner column in the June 2013 issue of MoneySense on newsstands May 13.)

Claiming investment expenses

Recently a reader, who had bought and rented out a condo as an investment, asked if he could claim the condo’s special assessment bill as an expense against the potential capital gains tax he’d owe once he sold the condo.

“He’s mixing apples with oranges,” says Albert Luk, lawyer with Devry Frank LLP, a Toronto-based law firm. You can’t claim business expenses against a capital gain—you can only claim deductions against business income (or annual expenses against annual rental income). If you want to reduce your capital gain you need a capital loss—such as selling stock that dropped in value.

Every investor has to make a decision, says Luk, either claim expenses and report the sale as income, or eat the expenses and sell the property as an investment, enabling it to qualify for the preferential capital gains tax treatment.

I won a home!

For the fortunate few, lottery wins are not taxable. That’s great news for one reader who wrote in asking how to calculate the capital gains tax on the sale of a home they won in a regional lottery.

“If you don’t already own a principal residence, the home can be sheltered from taxable gains through the principal residence exemption,” explains Scott Plaskett, president of IRONSHIELD Financial Planning, a fee-only firm in Toronto’s west-end.

If you already own a home, and decide to sell your winnings, the CRA will calculate your capital gains based on the difference in current market value of when you won the home versus when you sold the home. The longer you wait, the greater chance you’ll owe capital gains tax.

“I had a client who won a home in the Princess Margaret lottery,” says Plaskett. The client already had a principal residence and, though appreciative, wanted to sell the winning home quickly. The client sold and paid no tax, as the capital gain was almost nil from when he won to when he sold. “He was just tired of cutting the lawn.”

Renting out your basement

Many readers want to know if their home will continue to qualify for the principal residence exemption if they rent out a portion of their house. Their concern is prompted by stories of people who lost this exemption after years of renting out their basement.

While it’s true—you can lose your principal residence exemption—it really only happens if you rent out more than 50% of your home, or when you decide to claim capital cost allowance on the portion of your home that is the rental.

The CRA recognizes that, over time, depreciable property will become obsolete. Believe it or not, this also applies to real estate. Because of this you are well within your right to offset this loss in value by deducting the depreciation over a period of several years. This deduction is the capital cost allowance (CCA). However, if you claim CCA on your home, you are effectively telling the taxman that this property is used to produce income, and you use lose the opportunity to claim a capital gain, which is taxed much more favourably than income.

But what if you buy a duplex or fourplex and live in one unit while renting out the others? Can you deduct costs, including CCA, to offset the rental income you collect each year and still claim a principal residence exemption? Yes: but you’ll need to clearly document what portion is for personal use and what portion is rental. Only deduct expenses for the rental portion. When you sell, you can claim the principal residence exemption for the portion that was for personal use. To understand how this all works, consider the following:

• Buy a duplex for $400,000.
• Rent out one unit (for $1,500 per month) and live in another.
• Each year you report your annual rental income (about $18,000) and then offset these earnings with expenses associated with the unit. Remember: you cannot deduct expenses, including CCA, for the personal portion of the duplex.
• After four years you sell the duplex for $500,000.
• Because 50% of the property is used for personal use, you can shelter 50% of the $100,000 capital gain.

But be forewarned: CRA is cracking down on income generated from real estate, and in order to qualify for the principal residence exemption no more than 50% of a principal home can be used for rental purposes. For people thinking of buying and investing homes with a personal use portion you may want to seek out professional advice.

Gifting property (and avoiding probate)

In Canada, you can give gifts to loved ones without tax implications (at least for the recipient). However, this doesn’t mean you can completely avoid taxes when you gift money, stocks, shares or property. “There are tax implications on gifted property as the CRA sees this as a transfer of ownership, which is a deemed disposition,” explains Plaskett.

Still, many parents consider gifting property either upon death or before (by adding adult children to the title) as a great way to transfer property and avoid probate and other taxes.

“Because Canada doesn’t have a gift tax, like the U.S., people often get caught in tax traps when they start gifting without knowing the implications,” explains Luk.

If a parent gifts an adult-child real estate, the CRA considers this transfer of ownership as a disposition: a virtual sale of the property at fair market value. As a result the parent will owe taxes on any appreciable gain on the property (from when they bought the property to when they gifted the property). The parent can avoid these taxes if the gifted property qualifies for the principal residence exemption.

However, the adult-child will have to pay capital gains tax on the property should they decide to sell (and if they already own their own principal residence). The quicker one sells, however, the lower the chances of a capital gain, and the lower the chances of taxes owed. That’s because the capital gain is only calculated from the point of inheritance to the point of disposition. Add your adult-child to title years before you die and you’ll simply be increasing the potential for a capital gain and for taxes owed on that gain.

“It gets even more complicated if you gift property to a spouse or a related minor child,” says Luk, where the gifter may be hit with “an unexpected tax consequence known as the attribution rule.” This is when income, dividends and capital gains are attributed back to the gifter. “The take-away is that not all gifts can be given tax-free, even if there is no gift tax, per se.”

Sever land

Another option some readers have considered is to sever their land and to build two houses—keeping one home as their primary residence and gifting the other house to either a family member or the builder.

“This is a tricky timing issue,” says Plaskett. Anytime there is a change of use in a property the CRA considers this a deemed disposition. If the land originally housed their principal residence, then the gifters are sheltered from capital gains tax. However, the recipient—whether it’s a family member or the builder—would be subject to capital gains taxes if they built and then sold the additional home. That means if a builder built the two homes for $1.1 million, and then took possession of one and sold it for $750,000, the builder would owe tax on the $200,000 capital gain. Worse: because of the builder’s profession, this gain could actually be considered business income by the CRA, which eliminates the capital gain tax treatment on the sale of the house and forces the builder to pay his full marginal rate on the $200,000 profit.

If, however, the recipient chose to keep and inhabit the home as their primary residence, this would “make it a tax-free transaction,” says Plaskett.

Anyone interested in pursuing this type of gift should talk to a professional, as the CRA may have different rules depending on whether you sever the land before or after you build the two homes.

One building, two uses (business and residential units)

Those interested in diversifying their type of real property holdings may have considered (or already bought) a mixed residential/commercial unit. But when it comes time to sell there can be some confusion on how the capital gains tax will be applied.

“Whenever you have a mixed usage property you want to keep meticulous records,” says Plaskett. “Particularly regarding the value of the building or each unit during times of usage change.”

This will require owner to pay for an assessment or ask a realtor to provide a market comparison analysis and an evaluation of the fair market value of the building at each stage, says Plaskett.

By valuing each unit during each phase of use, you can determine your adjusted cost base (ACB)—a tax term that refers to the change in an asset’s book value.

For example, say you buy a home for $250,000 and live in it for five years before deciding to buy a larger property and keeping your initial home as a rental property.

Since you’ve changed the use of the initial house you are subject to capital gains taxes, but since it was your primary residence you can claim the exemption. This won’t work, though, when you go to sell this property a few years later. The good news: You can reduce the taxes owed by determining your ACB for the property.

By obtaining a valuation of the property at the time it stopped being your primary residence, you can shelter those capital gains from future tax repercussions. Here’s how it works:

• Buy a home for $250,000 and live in it for five years.
• Transition the home from residence to rental property.
• At that time, obtain a fair market value report (either from an appraiser or a Realtor) that values your home at $350,000.
• Sell the rental property three years later for $400,000.
• You will only owe tax only on $50,000, as the additional $100,000 gain is sheltered using the principal residence exemption.

Now, it doesn’t matter if the property is separated into different residential units, or commercial and residential units, the same principles apply.

Be forewarned: the ACB calculation can get a bit tricky. For instance:

• You buy a duplex for $750,000.
• You move into one unit and rent out the other.
• A few years later you move out of your unit and rent it out.
• At that time you obtain a fair market value report from a Realtor, which states that the property is currently worth $1 million.
• A year later you sell the duplex for $1.1 million.

In this example, only the $600,000 gain would be taxable at half your marginal rate, says Plaskett, as the principal residence portion of the building would be exempt.

Whether or not you made money can get even trickier if your ACB is lower than the current market value of the asset. “Always ask yourself: what did you take out of your jeans to invest,” says Plaskett. “And don’t forget: Anything you receive—whether it’s interest, rental income, or dividend—is part of your investment return.”

Tenants in common

When a married or common-law couple owns a home together the ownership is known as joint tenancy. This allows for the automatic transfer of the property to a surviving spouse without penalty or prior paperwork. (As with anything, this arrangement gets more complicated when you have a mixed or blended family.)

Yet, when adult children inherit a property they become tenants in common. This type of ownership allows two or more people to have equal ownership interests in a property. Unlike joint tenants, however, each can choose the beneficiary that inherits their portion of the property, should they die.  Where appropriate, tenants in common may also choose to sell their portion of the property, without consent from the other owners. And tenants in common ownership is not limited to people who inherit property. Many investors also opt for this type of ownership when there are two or more investors in one property.

When it comes to calculating tax, though, each tenant in common is on their own. “Everyone has their own adjusted cost base,” says Plaskett.

For instance, if two adult children inherit a property with a fair market value of $1 million and then rent it out, their adjusted cost base would be $500,000 each. A year later, investor A sells his portion of the property to investor B for $750,000. When investor B sells the property for $2 million, she will only pay half her marginal tax rate on $750,000 of the profit, because her ACB is $1.25 million ($500,000 plus $750,000).

Inheriting international property

In Canada you’re required to report your worldwide income and assets. Any profit earned on the sale of the foreign property is calculated in the same manner as non-primary residence property sold in Canada.

“Even if you own or inherit a home in Florida that doesn’t mean you avoid taxes,” says Plaskett. But there are ways to avoid taxes on foreign property. “If you put the property into a trust, so you don’t personally own the property, then you don’t have to worry about the capital gains once you sell the property,” explains Plaskett. The trust will pay U.S. tax, but will be exempt from Canadian taxation. Get expert help if you’re thinking of setting up a trust, however, as tax treaties and legal methods of minimizing tax can get complicated.

Getting hitched

You’ve fallen in love and you want to move in together, but you both own your own homes, what should you do to minimize taxes?

“There are several options for a couple where each person owns their own principal residence but they want to move in together,” says Albert Luk, lawyers with Devry Frank LLP, a Toronto-based law firm.

The first option is to sell one of the homes. This person could claim the principal residence exemption and avoid paying capital gains taxes. But to qualify for a principal residence exemption you will have to sell the home before getting married (or moving in together). Under tax laws a family unit can designate only one property as their primary residence—and a family unit includes spouses and all dependent children.

The second option is to convert one home into an income producing property by renting it out. You will trigger capital gains taxes but only from the time you started renting out the property to the time you actually dispose of the property. That’s because the CRA considers the change in the use of the property as a deemed disposition—tax talk for a change in use of a property is the equivalent as a sale at the current, fair market value.

If you opt to keep the second home as an income property you can minimize the taxes owed by keeping good records. “Get an appraisal or a property valuation just before you change the use of the property,” says Scott Plaskett, president of IRONSHIELD Financial Planning, a fee-only firm in Toronto’s west-end. That way when you go to sell the home, the capital gains tax will be calculated from the time the home became a rental property, not from when you first purchased the house.

Getting divorced

A few readers ask what the process is for calculating capital gains tax on a home that was part of divorce proceedings.

If the divorce is short and sweet—and both parties have vacated the home in order to quickly sell the property—then taxes would only be owed from the time the home stopped being a primary residence for the couple until the time the property sold.

The longer it takes to sell the property the greater the chance for potentially higher capital gains taxes being owed. (The assumption being that the property will appreciate over time.)

If, however, one half of the couple continues to live in the property and chooses to buy out the other half, there will be no capital gains tax owed as the home is still being used as a primary residence.

First: I am a licensed Realtor. We state this upfront in my bio. There’s no hiding this fact, as we, at MoneySense, believe it’s very important to address potential conflicts of interest. But the fact that I hold a real estate license and write/blog about housing does not inherently produce a conflict of interest.

In the past, I have candidly written articles and blogs on ways to save money on real estate, as well as problems inherent with the profession—often angering real estate agents in the process.

Here’s a sampling:

How to Pay Your Realtor Less

Find the Perfect Real Estate Agent

Perfect Home and Still No Offer

RBC, erosion of housing affordability

Fixer Upper or Money Pit

Delicate Art of Negotiation

As such, I do not believe my decision to become educated about real estate prevents me from objectively writing about the industry, the profession, or on real estate as an investment product.

To clarify, I was compelled to become a licensed Realtor in order to complete my two years of articling—the “on-the-job” educational component for the profession. Hence, I am a licensed Realtor through a Century 21 office. I believe this part of my training makes me a stronger writer and advocate for the MoneySense philosophy.  (I would also like to clarify: my Realtor education did not take four weeks as one reader has suggested. I know my family certainly wishes it had!)

The fact that I’ve been a journalist for almost 15 years and a financial journalist for more than a third of that time, means that my primary job is to provide advice that is best for our readers. I chose real estate because it’s an area I am passionate about and an area where I believe our readers can learn to save money and derive value. I believe I have done a part in that—both as a blogger, columnist and writer, but also as the magazine’s behind the scenes expert (fielding question after question from other writers and pointing them to sources that will provide key information to our readers).

As my former editor once said, “We at MoneySense should never offer advice we wouldn’t give our own mothers.” As a real estate investor, I definitely eat my own cooking.

Now, as for TD’s research report. Does it have the potential for bias? Of course. TD is a big player in the mortgage market. But unless you believe the housing market will experience a crash similar to the U.S. housing and credit crunch in 2007/2008—and I don’t—then the debt currently held by TD will not be impacted by a correction in housing prices. For that reason (and because economists are sensitive to being wrong…which happens often) I don’t believe TD, or Scotiabank for that matter, has inherently tainted their research.  For that reason, alone, the report was worth mentioning.

But there are other reasons. In the last five years we’ve been inundated with reports and declarations from international economists, organizations and media outlets that have crunched their own numbers and predicted massive upheaval in the Canadian housing market.

Personally, I believe these reports—often with a 20% to 25% decline in housing prices across the country—are inflated. Housing is a regional market indicator and large-scale predication of doom and gloom have done little more than fuel paranoia and, ironically, induced inflated sales. I think reporting on more moderate housing correction predictions and the reality of housing appreciation helps homeowners and investors understand that there’s no reason to panic—and thus no reason to temporarily inflate sales, which keeps housing prices artificially high.

The fact is my blog is a catch-all for anything homeowner related (hence the blog title Home Owner). My intent is not to re-crunch the numbers (for a great blog on stats see: www.economicanalyst.ca), but to provide information on how to make smarter financial decisions when it comes to homeowner issues. If that means highlighting a report that offered something other than the “sky-is-falling” housing crash predictions we’ve read as of late then so be it. And I’m not the only one. MoneySense Senior Editor, David Hodges, wrote an excellent and unbiased piece on the lack of a housing bubble (much in the same tone as my blog, might I add). To read this excellent piece go to: No Bubble, No Trouble.

That’s a far cry from the headlines that promised nothing short of a drastic housing price drop:

• Be Very Afraid of the Canadian Housing Bubble (CBC.ca, April 16, 2012)
• Merrill Lynch Warns of Canada Housing Bubble (Macleans.ca, Dec. 20, 2011)
• Is Canada’s Housing Rebound Forming a Bubble (realtytimes.com, Nov. 24, 2009)
• Home Prices Could Dive If Rates Rise (Globe and Mail, Feb. 2, 2011)
• Our Unstoppable Housing Market May Have Met It’s Match (National Post, March 28, 2010)
• Housing Prices Due to Fall, says think-tank (The Star, Aug. 31, 2010)
• Canada Bank CEOs Warn On Housing, Not Europe (Reuters Canada, Jan. 10, 2012)

…and the list goes on.

The more sober call for a “gradual adjustment” comes from a recent TD Bank report. The report, released this week, suggests that the real rate of return for housing prices, post 2015, will be about 3.5%. This shift from the average 5.4% return we’ve seen year after year for the last decade is due, in part, to a number of macroeconomic fundamentals, such as a slow rise in average incomes, a close to stagnant national economic growth rate, Canada’s aging population and immigration figures.

In short: we are returning to pre-1998 housing valuations, when nominal rates of return on real estate matched inflation at around 2%. (For those that keep track, there was a surge in home prices between 1982 and 1989, and again between 1972 and 1977).

The silver lining?

For the last few years economists, financial analysts, and bloggers have warned us about the forthcoming housing crash. Don’t get me wrong, there’s still a potential fall out when this nation of debtors finally comes face to face with the impact of rising rates, but the silver lining really is that housing prices in Canada are flattening out, and returning to stable levels.

While sellers may be disappointed, buyers won’t be (nor should sellers, since most of us have to buy when we sell). This is particularly true for the next couple of years, as housing prices start to gradually drop in value.

As Kenneth Rosen, chairman of the Fisher Center for Real Estate and Urban Economics at the University of California-Berkeley, points out: “Prices are back to [increasing] 1% to 2% more than inflation over the next 10 years,” right in line with long-term appreciation averages. According to data compiled by Yale University professor Robert Shiller, U.S. home prices increased, on average, by 0.5% per year from 1890 to 2008. A 3.5% real rate of return over the next 10 years doesn’t look so bad.

In their new financial model report, Fitch analysts noted that housing prices in Canada have continued to climb since 1996 and, while small corrections have occurred, these prices have risen without the support of underlying financial fundamentals.

For that reason, the ratings agency suggests that the overvaluation of real estate in certain provinces is in the double digits. For instance:

• Ontario is overvalued by 21%
• Alberta by 15%
• British Columbia by 26%, and
• Quebec by 26%

Still, Fitch analysts don’t believe the overpriced real estate markets will result in price declines that equal or exceed the overvaluation rates.

“Actual nominal [price] declines could range from the low single digits for Alberta, up to more than 15% for B.C. and Quebec.”

The key: these declines will occur over the next several years. More importantly, the price decrease will be closer to 10% of home prices not 20%, explain Fitch analysts.

Of course, certain markets have already felt the pinch. In Alberta, low crude oil prices in 2008 forced a price correction. In B.C., there was a 29% drop in year-over-year sales in February—signalling a cooling in what is considered Canada’s most overvalued market.

For buyers willing to sit out another five or so years this could mean a drop in home prices. For example, a home listed for $450,000, today, could drop in cost to $405,000 within the next five years.

Good news for the patient homebuyer, but the decision to wait and buy should also factor in potential rising interest rates as well as job security and economic growth. If discounted five-year posted interest rates go up to 5% in the next five years—an increase that’s not out of the realm of possibility—then you would pay $2,249 per month (based on a 5% five-year fixed rate for a 25 year amortization on a $405,000 home, with 5% down). If you bought now, you’d be paying $2,025 per month (based on a 3% five-year fixed rate mortgage for a 25 year amortization on a $450,000 home, with 5% down).