I keep thinking there are some real opportunities to take advantage based on the idea of borrowing to invest (and the tax write offs revenue Canada offers for them).
Say I owned my house free-and-clear, and pay a 40% marginal tax rate (20% on dividend income). I could get a fixed-rate mortgage for 80% of the value of my home for 5.75% right now (3.3% after taxes, since I’m borrowing to invest and this is deductible). If I can safely get a 4.125% after taxes dividend-yield on my investment, then my dividends will pay for my mortgage.
Say instead, I deliberately sacrifice some yield and buy equal amounts of the big-6 banks (average dividend yield on them is around 3.25%, 2.73% after taxes in this case, right now I think). I’m now paying 0.57% on my mortgage (and the dividends are covering the rest). This is certainly a loss (since the 0.57% is coming out of my pocket), and people always say “don’t lose money just to spite revenue canada”, which makes good sense. HOWEVER I haven’t considered any capital gains or dividend increases in this situation. As long as the AVERAGE increase on these 6 bank stocks is greater than 0.57% a year (very likely if I’m holding for the long term), I should come out ahead. I will have to pay capital gains when I sell, but that will hopefully be at a point when I’m earning less income (or else why would I be selling?). Additionally, since I’m in a fixed rate mortgage, hopefully the dividends will increase (but the interest rate can’t), so if the dividends go up a little bit then I’m not out any money any more.
You could maximize this “risk protection” by going with a longer mortgage term (currently you could get a 10 year mortgage for 6.04%).
On a $200,000 mortgage this would cost $1140 / year, a nice little investment for $100 / month.
Obviously I’d be paying taxes when I sold the stocks (capital gains) or when the dividends increased, but that seems to be shifting my tax burden into the future (the same way an RRSP would), which people generally seem to feel is a good idea.
The risk to this is that the banks cut their dividends and all go bankrupt, then you’re back to paying a mortgage from scratch (as if you’d just bought the house). That would certainly suck, but I think the chance of *all* the banks dropping significantly is pretty small.
If I accept this risk, and want to get even more aggressive, I could choose a cash-back mortgage which would increase the interest rate (and hence the deduction) and provide more cash to buy dividends with (I would be counting on an increasing dividend / capital gains to compensate for this). This would cost more right now on a monthly basis, but that’s what I want (to shift income and taxation into the future). Getting EVEN MORE aggressive (I’m scaring myself now) would be to get the mortgage with the cashback, then buy the stock, then buy even more of the stock on margin (E*Trade would allows you to buy 70% on margin for stocks valued above $5). In theory you could buy $363,800 worth of bank stock (with a 200K mortgage, 7% cashback and 70% on margin). The stock could drop 41% before there was a margin call (and if you were earning a good income or had other liquid investments you could probably meet the call if this happened).
You could (if you had the extra income and wanted to maximize the future income) even keep buying additional stock (on margin) with the dividends and pay the mortgage payments with your income (assuming you could afford the full mortgage payments). This would be more a forced-savings / dollar-cost-averaging strategy rather then a taxation strategy though.
The “reasonable expectation of profit” that Canada Revenue insists on is certainly there (it wouldn’t be unreasonable to expect the stocks to go up 1% over the next year in the least aggressive situtation detailed above).
Does this work as I understand? Why don’t people do more of this (buying on margin / on mortgage for tax purposes instead of for leverage purposes) once they’ve maxed out their RRSP’s?
Thanks in advance for any thoughts or pointers to relevant books / articles!
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