Deductible Borrowing

by Mr. Cheap

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Now that I’m living off of savings, I expect at some point I’m going to have to dip into my line of credit. Since its always better for debt to be deductible (save you money on your taxes), rather than non-deductible, my plan is to start borrowing money to pay for my condo expenses.

How this will work is, I pay $126 every week for the mortgage payment (principal and interest) and $500 a month for condo fees. On the day the expense are paid, I’ll transfer an equivalent amount from my line of credit into my checking account (where these expense are drawn from).

This will put about $1000 / month (plus interest) on my LOC, while I should be able to live off of the $1300 / month that my condo is bringing in in income. I have a few thousand in savings which I’ll use for any unexpected expenses. Once I start my PhD (or bring in some coin from contract work), I’ll start paying down the LOC.

The benefit of doing this will be that I’ll get a tax deduction on the 9% interest I’ll be paying on this every month (since I’m using it to pay for investment related expenses). If I waited until I ran out of savings then started borrowing from the LOC for personal spending, it wouldn’t be deductible.

I’ve ran this past a couple of friends and I’m pretty sure that its valid. If anyone knows if this isn’t allowed (or can warn me of any potential pitfalls), I’d be very interested.

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{ 18 comments… read them below or add one }

1 TheFinancialBlogger

Sounds like you just define the cash damming with a rental property instead of a company! However, since your income seems low for now, the tax deduction will not become a big benefit :-(

2 telly

One note of caution:
only the interest portion of the mortage payment (not the principle) is deductible for a rental property. Therefore, the interest paid to the LOC to pay the principle would not be deductible.

3 pessimist

I’m sorry to nitpick but it is ‘principal’ not ‘principle’.

Also, wanted to say I enjoy your blog immensely.

4 telly

I just copied – too lazy to look it up. ;)

5 Mr. Cheap

FB: Yeah, after I wrote this I was surfing around and came across “The Cash Dam” and the concept definitely seemed similar (although I’m not trying to pay off a mortgage).

telly: shoot, I think you’re right. Good thing I posted about this. Any suggestions how I may be able to break my principal apart from the interest and put it on the LOC? Maybe I should just put the condo fees on it and hope that lasts until I have more cash coming in…

pessimist: Thanks for the correction! I’ve updated it in the main post (so now just telly will look bad ;-) )

6 Commander T

The only issue I could possibly see with this issue is if you are using the LOC for personal purposes right now. If you are then you would be co-mingling your deductible debt with non-deductable debt.

I don’t see why paying the Mortgage principle with the LOC would create a problem. All you would need to do is add up the interest portion of the mortgage paid and the interest on the LOC and you would have the interest expense for the year. Since the Mortgage on the rental property and the condo fees are paid in order to earn income from property then the all of the cash borrowed on the LOC is for income producing purposes and so all interest is deductible.

7 Mr. Cheap

Commander T: That was my original thinking too. That I’m just moving the principle from the mortgage (where interest on it is deductible), to the line of credit (where interest should still be deductible on it).

I don’t have any debt in the LOC right now, so the mingling won’t be a problem (and if I got to the point where I had to use it for personal purposes, I’d stop using it for a deduction).

Thanks for the comment, glad I posted about this, I’ll keep digging to see if its ok or not…

8 telly

Cheap, when we started our renovations on one of the rentals we decided to use borrowed money (that was deductible) rather than use money out of our pocket. Only now are we at a point where income covers the expenses so we were essentially doing the same thing. We pay utilities so that comes out of the LOC but we’ve never used the LOC to pay the mortgage.

If you can’t deduct the entire mortgage payment from your income when you file your taxes, I don’t see how you could borrow to pay the mortgage principal and consider that deductible. It doesn’t seem to make sense but I’m not sure.

To me, this is similar to the argument of deducting interest for the purchase of non-dividend paying stocks. You can’t deduct the interest if the expected gains are capital in nature (i.e. growth of non-div. stocks or in our case, appreciation in property value). You make a point though Commander T because the mortgage itself is required in order to create “the expectation of producing income” in this case.

Lastly, MC, if it’s still possible based on your credit, I would open another LOC that you could use for personal reasons if you needed to. Losing the deductabilty on your current LOC for a bit of spending cash, short-term, would be ashame. PC offers unsecured LOC’s at prime + 1%.

9 Mr. Cheap

telly: yeah, I agree. Unfortunately, now that I’m not working I doubt I’d be in a good place to get approved for a LOC… :-(

I calculate how much of each of my payments goes toward interest and how much towards principle myself, could I use that to “justify” that I’m only moving the interest portion of the payment onto the LOC? E.g. right now from my last payment, $38.12 went to principal and $88.39 went to interst, so could I withdraw 88.39 from my LOC? I caculate this myself though (its not from my bank), so I may be off by a penny or two…

FB is correct that given my low income, it won’t make a huge difference (in 2008 anyway, I’d like the deduction for 2007 if at all possible).

10 telly

I’ve thought about doing that as well and I could totally see that being justified (calculating the interest portion). I would just recommend keeping good notes / records just in case.

11 Four Pillars

Sorry to be so late to comment but it’s taken me this long to figure out what the heck you guys were talking about!

I’m no expert on real estate investing taxation so feel free to ignore if I’ve got this all wrong.

Mr. C – The interest on the mortgage is tax deductible because it’s for an investment property (we all agree on this). If you were to borrow from a LOC to pay that mortgage interest (which is already deductible) and then you write off the interest of the LOC, isn’t that double dipping? I don’t know if that is allowed or not but intuitively I would think it isn’t.

As far as the condo fees go and Telly’s renovations – are those not expenses which in themselves should be tax deductible? If you borrow from the LOC to pay for deductible expenses and then write off the LOC interest I think that is also double dipping.

Anyways – feel free correct/praise me…. :)

Mike

12 telly

Hmmm…you make a valid point Mike.
I hope you’re wrong though! :)

If you read up on the cash flow dam (extension of the SM), they mention this technique and recently I read somewhere that it was questioned (and subsequently “approved” by the CRA). But I don’t remember the details, or where I read it so I’m really not offering much here am I?

13 Four Pillars

I found this on Smith (of SM fame) website – the fact that I can’t find it anywhere else is a bit troubling.

http://www.smithman.net/cashflowdam.html

He does say to borrow to pay the expenses and generate deductible debt so you guys have that right (assuming Mr. Smith is right).

I’m assuming this would include condo fees and maintenance and renos.

I’ve never read his site before – I really think he is a moron :)

Mike

14 Mr. Cheap

You can definitely write off interest paid on a debt used to pay condo fees and renos (I think we’re all agreed on that, and I’ll start doing just that until I figure out the mortgage rules).

why don’t you tell us how you really feel? ;-)

15 Mr. Cheap

I’ve been looking all over, but I haven’t been able to find it again. Some time ago I found information on a government tax law site that basically said, if you’re borrowing money to pay something that’s deductible, the interest is deductible, otherwise its not (which would support deducting interest paid on a loan for condo fees).

If anyone has a link to more information, I’d like to reasure myself that I read this right…

16 telly

You’re right Cheap. After thinking about it more, I realized that Mike’s idea of this being double-dipping is incorrect. One is deducting the actual expense while the other is deducting the interest paid on that expense. This should be fair game (so just take my word for it because I don’t have a link ;)).

17 Mr. Cheap

I *think* I’ve found the relevant law. Look at: http://www.canlii.org///ca/sta/i-3.3/sec20%2Ehtml

Specifically, I think this section covers what I’m talking about:

Compound interest

(d) an amount paid in the year pursuant to a legal obligation to pay interest on an amount that would be deductible under paragraph 20(1)(c) if it were paid in the year or payable in respect of the year;

Would you agree with my reading that I can move the entire mortgage payment onto my LOC and deduct it?

20 (i) borrowed money used for the purpose of earning income from a business or property

Seems to me to clearly support putting the condo fees on my LOC and deducting them (I’m borrowing money to pay expenses that result in my earning income).

Plus, since I’m earning a profit on the property, it clearly meets the “reasonable expectation of profit criteria.

18 FourPillars

Well there you go – as predicted I didn’t know what I was talking about.

It’s good to learn this stuff.

I still think it’s double dipping but who cares? It’s whether it’s allowed or not that is important.

How I really feel – I supposed it applies to any type of marketing but I get annoyed when people misrepresent something. He talks about your mortgage “just melting away” like he’s found some magic potion – nary a word about any possible downsides.

Mike

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