Tax Deductible Mortgages / Debt

by Mr. Cheap

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Some time ago a reader, Ben, asked for feedback on a strategy he is considering which he describes as a variant on the Smith Maneuver.  My hat is off to Fraser Smith as he has successfully attached his name to something that is a fairly general strategy based on not much more than the Canadian tax code.

If you thinking about buying tax preparation software then consider software programs such as TurboTax or TurboTax Canada (formerly QuickTax).

The Smith Maneuver

The Smith Maneuver has been very well described at Million Dollar Journey and The Canadian Capitalist.

The core of the idea is to convert your mortgage debt, which is NOT tax deductible in Canada, into an investment debt (which is) and by doing so “make your mortgage tax deductible”.  The Smith Maneuver itself actually builds beyond this idea and uses a readvanceable mortgage (many people want to avoid this part and just use a HELOC, which Fraser Smith discourages) and often invests in segregated funds.

Basically each month you’ll pay down your mortgage, and use the extra equity portion of the payment (principle repayment) to invest.  When you re-borrow this for investment purposes, it becomes tax deductible.  Your mortgage stays about the same, but as time goes on it keeps getting converted into a deductible loan instead of a non-deductible mortgage.  You can use the proceeds from the investment, or tax refunds to further pay down your mortgage and accelerate the process.

Canadian Tax Code

The key behind all of this is line 221 from your tax return.  Many people have an aversion to reading tax laws (or even tax instructions) assuming that it’s as obscure as ancient greek.  Much like Shakespeare, it LOOKS harder to understand than it actually is.  Read over the linked to page once without even trying to really understand what you’re reading.  Then go back, read it slowly, and be willing to re-read any sentences that don’t make sense.  Have faith in your understanding of terms that are familiar, and look up words and phrases that aren’t.  It gets easier the more you read.  If you really get stuck on a part of it, post what you don’t understand to the forums at Red Flag Deals (I horribly omitted them from my recent post of Canadian discussion forums), Canadian Money Forums or Canadian Business Online and someone should be able to help you understand.  Heck, you can even call the Canada Revenue Agency (CRA, our IRS).

The key parts we’re looking to take advantage of are, is the deductibility of:

  • Most interest you pay on money you borrow for investment purposes, but generally only as long as you use it to try to earn investment income, including interest and dividends. However, if the only earnings your investment can produce are capital gains, you cannot claim the interest you paid.”

and

  • Fees to manage or take care of your investments“.

What this let’s us do is borrow to make an investment where we expect to earn more than we pay in interest.  This makes sense, as losing money on an investment to try to save taxes is pretty dopey in the first place.  One thing I looked into is that if you borrow money to pay the interest on a tax deductible loan, the new money borrowed IS deductible (so you can let the loan compound).

A Non-Smith Maneuver

Say I had a mortgage on my principle residence, and bought an investment property that was breaking even (lets say it cost me $1300 / month and I collected $1300 / month in rent). Let’s say I have a $100,000 4% interest-only mortgage and I’m paying $334 / month on it (the interest) and I can afford to pay this every month.

First I get a HELOC on my principle residence (I could get it on the investment property, but if the expense equals the income it probably doesn’t have the equity, plus it’s easier to get a HELOC on a principle residence). Say the HELOC is 6%.

Each month I pay my principle residence mortgage payment from my income and that’s taken care of. Then I also put down an extra payment of $1300 (from the rental income) of the mortgage on my principle residence. Doing so creates $1300 of extra room in the HELOC. I pay for the $1300 in rental expenses from the HELOC, and the interest on this $1300 debt is now tax deductible, since I borrowed it to pay for investment expenses (along with any amount on the HELOC which was used to make the down payment on the property and to pay for transactions fees, such as a lawyer, RELATED TO THE PURCHASE OF THAT PROPERTY).

I still have to pay tax on the $1300 in rent (it’s income). I’m also converting a 4% loan into a 6% loan. Even if it’s tax deductible, that doesn’t seem like the smartest idea in the world. Additionally, if my mortgage is fixed rate, I’m trading the certainty of my payments for the variable rate of a HELOC.  It *MAY* be possible to roll the HELOC into a lower interest second mortgage, or somehow have a segregated mortgage (that splits the deductible portion from the non-deductible portion), but I don’t know anything about either of these.

Ultimately, once my mortgage on my principle residence is paid off (after 76 months, or 6.5 years if we ignore the increasing interest on the HELOC and the decreasing interest on the principle residence mortgage) I can, of course, get a new, tax deductible mortgage to replace the HELOC. This process would be accelerated if there was more than one investment property (or if the income / expenses of the rental property was higher).

Other Alternatives

This is an example with investment real estate, but you could do the same thing with investing in blue chip dividend paying stocks, starting a business, buying  a franchise, or many other investments.  A while back I suggested Mike consider doing this with the blog (which wouldn’t be a FAST way to make his mortgage tax deductible, but would nibble away at it as time went on).  Basically any investment that earns income and has expenses can be structured this way to “convert” your mortgage into a deductible loan (by paying down the mortgage with the income, and borrowing to pay the investment expenses).

There is a great discussion on borrowing to invest on the Red Flag Deals site.

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{ 13 comments… read them below or add one }

1 Henry

I don’t think segregated funds are good ideas. They have management fees of close to 5% from the ones I have seen.

Maybe some sort of market timing using index funds or ETFs might be better so that you can avoid the majority of bear market pain on leveraged money. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=962461

2 Brendan

Mr Cheap you are right that Fraser attached his name to this but his method is a little more than simply borrow to invest.
Borrowing to invest and deducting the interest is nothing new, but I believe that his method of shifting your mortgage debt over time to a deductible loan is kind of unique?
I could be wrong but until i read his book, i would not have thought about doing it this way. I would simply just borrow with a HELOC and invest.
He also suggests interest “capitalization”, by pulling out your interest due on the HELOC and re depositing it as an interest payment. He claims this is also deductible.

Just wondering if you have an opinion , or perhaps know someone who has been successful at deduction compound interest on an investment loan.

I have a hard time believing this as you are building a non registered portfolio with no hit to monthly cash flow, AND you get refund checks to boot.

Of course Canada will benefit with me being less reliant on gov’t pensions, not to mention investment in Canadian companies, creating jobs, future tax payers, etc. Don’t forget the bank still makse money on a loan which offsets the interest they are losing as I pay down the house.

I was also wondering your thoughts , as well as others about the SM replacing an RSP.

Right now I max out my RSP, and TFSA accounts.
BUT I have a defined benefit pension (shhhh! don’t tell the people on the TO garbage thread…they will be mad at me!! lol) and i am starting to think that I would be be better off using the RSP contribution to pay down the mortgage even fast, thus re borrowing faster to invest.
Not to mention I will have a portfolio of Canadian stocks paying tax advantaged dividends. (I also plan to retire in BC where dividends are taxed the best)

This would also allow me to carry forward RSP room so that when I retire i can stash my sick time cash out that i don’t deserve. (shhh! the garbage thread people will hate me)

3 Mr. Cheap

Brendan: Yes, my understanding is that pulling money out from, then redepositing to a HELOC keeps it deductible (this is just a manual way of compounding, if a HELOC didn’t require monthly payments this would be unnecessary).

I’ve been successful at deducting compound interest on an investment loan (my margin debt in my investing account). I haven’t been audited, but I’m confident enough that it’s allowable that I’m announcing it on a public blog :-).

I view a SM as a very different beast than a RRSP. Which makes more sense depends on the person (shooting from the hip, I’d imagine that maxing out their RRSP would make sense for MOST people before getting into a TFSA or a SM).

For someone with low income, a case could easily be made for paying down their mortgage (and possibly NOT borrowing to invest) .

4 ethan

Hi,
I read somewhere that not all investment are tax deductible. I am thinking of borrowing to invest on TD eSeries Canadian bond, equity and US index aka coach potato. Would that be tax deductible. I am not sure if dividends are issued and if they are how do I prevent them from being reinvested and getting a tax receipt/t5 for it ?

5 Brendan

Mr.Cheap I am not sure what triggers an audit with CRA. I would think that as long as your interest deduction was in line with the investment income than it should be good. Who knows. The important thing is the paper trail.
Funny thing is that Credit Unions will capitalize their HELOCS, but will not do a re advanceble mortgage and major banks will re advance, but will not capitalize.
As for SM/RSP, I was doing some calculations. When I retire I will be in the same tax bracket as I am now. So, I am thinking maybe a non registered portfolio would be better than the RSP.

6 Mr. Cheap

Ethan: They discuss that in the red flag deals thread I linked to. I believe you’d be fine with the equity portion of the couch potato (and I *THINK* you’d be ok with the bond component too).

You’ll get a tax receipt for any dividends. If they’re re-invested, that slows the process down (prevents you from using it to pay down your mortgage), but it still works.

Brendan: They’re quite tight-lipped about the algorithm they use to pick people for audits.

Don’t forget that even if you’re in the same tax bracket when you retire, deferral of taxation is a MASSIVE benefit.

7 Brendan

You said you looked into “if you borrow money to pay the interest on a tax deductible loan, the new money borrowed IS deductible”.

Just curious how you went about this?
I just got off the phone with CRA and I was told the original loan interest is deductible, but if you withdraw and redeposit it is NOT deductible because the amount you withdrew was not used to invest, it was used to pay interest.
Weird because I then asked about IT533, and deducting compound interest. The CRA guy put me on hold and then read me the actual tax act. He talked about compound interest being deductible as long as the compounded interest was used to service a loan that was originally used for investing. (exactly what we do in the SM).
But he then said this would not apply to situation because I was taking money out of my line of credit to pay interest, NOT invest, therefore the “interest payment withdrawal ” would not be deductible.
I then told him THAT’S what compounding is. Except that i am manually compounding.
He then took my name/number down and someone from rulings is gonna call me back with an answer.
WTF??
I don’t get it. Compound interest either is, or isn’t deductible. Should be cut and dry.
I think maybe the CRA guy didn’t understand manual compounding at all. He kept putting me on hold to “get an answer”. I asked to speak with whoever he talked to while I was on hold. Said he couldn’t do that. Lol.
Hopefully CRA auditors are just as stupid.
Just curious if you got the same clueless run around, and how did you finally get your answer.

8 Mr. Cheap

Brendan: Absolutely, GENERALLY if you withdraw and redeposit, it is no longer deductible. What I was referring to is if you allow the debt to keep compounding (so you’re paying interest on interest) and this all remains deductible. This is what the guy meant by “compound interest being deductible as long as the compounded interest was used to service a loan that was originally used for investing”.

I *BELIEVE* if you withdrew money to pay a deductible debt, interest would still be deductible.

For example: I have a HELOC used for investment property expenses and a margin debt, used to invest in blue chip socks. Both debts are deductible. If I get sick of having to watch the margin debt (say I’m worried about a margin call while I’m out of town), I can use the HELOC to pay off some or all of the margin debt. The HELOC remains entirely deductible (since the debt was “moved” from the margin loan to the HELOC).

As another example: Say I have a deductible HELOC (as above). I’m going on a trip to Hawaii and I borrow $1000 from it. Upon my return, 3 weeks later, I repay the $1000. This part of the HELOC is NOT DEDUCTIBLE (it wasn’t used for investment purposes), and if I’m ever audited, it will make the deductibility of the HELOC questionable from that point on. This is what the guy at CRA thought you were asking.

With the CRA you want a VERY CLEAR paper trail of everything you do, and why you’ve done it. I *believe* if you withdrew and re-deposited to a LOC on the same day (or within a day or two), you could make a very clear case that you were manually compounding (and the withdrawl and redeposit was simply done to meet the “minimum monthly payment” required by the bank).

Remember that people are human, and not everyone who answers the phones at the CRA will understand exactly what you’re talking about. I think you have the right idea (and he misunderstood what you are describing).

I got my answer by reading the tax law (which I posted a link to), and reading through a number of discussions on Canadian Business Online (where they addressed the law, and gave examples).

I’m sure when the right person returns your call they’ll verify this (and please post a comment when / if they do, it’s always great to get more verification that what we’re doing is legit).

9 Brendan

He knew my HELOC withdrawal was to pay interest charges. I used the example of 100 dollars being due on July 10th. On July 8th or 9th, I withdraw 100 from the investment HELOC and deposit it into the checking account that the HELOC will debit the interest payment from. On the 10th the bank account is debited 100 dollars, paying the July 10 interest charge, and adding 100 to the HELOC.
I explained the both the checking account, and HELOC were for the exclusive use of investing, and facilitating the HELOC interest payment.
I think this was above his head, and didn’t understand what i was doing.
IT533 mentions compound interest is deductable on a cash basis only.
Again he could not clarify cash vs accrual basis.
Mr Cheap do you know what CRA means by accrual and cash basis?
I understand accrual is accounting for things that actually havent been recieved yet i.e suppliers order from you but havent actually paid. Cash method would mean the company actual has the payment in the bank.
I do not know how this cash/accrual applies to investment loans.
The fact that you use the term *BELIEVE* leads me to understand that it is questionable.
ANyway i will post back when I hear from CRA. I am told you can actually go in person to talk to people at CRA and get a straight answer. I looked into an advanced ruling, but they want alot of cash up front for an answer they should already know.
We cant possibly be the first and only people to do the SM?

10 Mr. Cheap

Brendan: I think the bulletin you referred to (IT533 http://www.cra-arc.gc.ca/E/pub/tp/it533/it533-e.html) answers your original questions quite well.

I also think you’re right that the employee was trying to help you with something that was over his head. I wouldn’t try to make sense of what he told you (wait for the senior person to contact you, and read the bulletin while you wait). I don’t think cash vs accrual is relevant for you.

Cash method: http://www.cra-arc.gc.ca/tx/bsnss/glssry/c-gn-eng.html#method
Accrual method: http://www.cra-arc.gc.ca/tx/bsnss/glssry/a-gen-eng.html#accrual

When I ran my business before, I used the accrual method, since I was starting small (and hoping to grow), so I wanted to capture all the income I could ASAP (hoping that the following year would be a breakout year and I’d make far more income).

11 Brendan

Here is an update. I received a call back from CRA (not the rulings dept, same main desk I originally called, but someone with more knowledge and also looked further into my situation).
He knew right away i was doing the SM, and said to the best of his knowledge CRA has not attacked the SM, as it is legit, ie. borrowing to invest to earn income, which means more tax revenue, more canadian jobs which equals eeven more tax revenue etc. It is not simply a scheme where there is no benifit to anyone other than the person trying to get a bigger refund.

He brought up a couple of points. it533 para 16 talks about cash damning. Not cash damning ala Fraser Smith but cash damning in terms of keeping everything seperate.
The main HELO should be segregated for investing only (duh), but he also said that i could “compound” my own loan provided that it be done via a seperate bank account used for investing/HELOC servicing only. Do not use your everyday checking account to deposit and pay your HELOC. He also said that if the bank charges you a monthly fee for the account, it could also be deducted.
So basically you can deduct compound interest auto or manual, so long as everything is kept separate and can be traced easily in the event of an audit.
He also recommended for piece of mind to get an opinion from CRA (wasn’t that the whole point of him phoning me back?) by looking up the advanced information circular IC 70-6R5.
I will send an email outlining what I am going to do. It will be interesting to see what this dept has to say. I suspect they have already heard of the SM.

I will post back when I hear from them.

12 Ed Rempel

Hi Brendan and Cheap,

There is no problem with capitalizing the interest or the Smith Manoeuvre in general from a tax perspective, if you keep good records and don’t take money out of the investments.

You are not the only ones lookin at it. We have hundreds of client families doing it and we do their tax returns to make sure they have no issues (since I am also an accountant).

Normally, you can’t trust what CRA tells you, since most of their phone people are not very knowledgeable. CRA’s policy is that they are not bound by anything their people say on the phone. However, you seem to have found a knowledgeable person.

There is a lot of useful info on the internet, especially on the www. milliondollarjourney.com site, if you want more info.

Ed

13 Brendan

I find that CRA will give you a different answer each time you call, dependent on the time of day, what day of the week it is, and the planetary alignment of the sun to earth ratio.
All kidding aside, it is not that I am doubting anyone. I just like to do my due diligence.
I am still leery of the compound interest deductability.
Building a portfolio with zero cash flow, and your deduction grows as your interest charges go up. It just seems too good to be true.
Usually CRA will have rules that are to their advantage only. i.e you HAVE to pay capital gains tax when depositing stock into an RRSP, but you cannot declare losses.
When you borrow to invest you are buying investments. When you capitalize interest you are not using borrowed funds to produce income, you are servicing debt. I am surprised this is allowed. IT 533 is vague to me. Compound interest is deductible but only on a cash basis.
This means what?
I am also wondering why no one has yet to offer a full SM loan/mortgage package, given the increase in demand, as well as everybody wins in the long run.

Banks readvance but dont capitalize, and credit unions capitalize but do not readvance.

I went into my local credit union, just as Fraser Smith did years ago , with the hope i could pave the way for Winnipegers to to have a full blown turn key SM solution. Just like the TDMP people but with out the high fees.

The CU folks simply thought I was nuts, and I thought they were going to have security escort me out of the building.
I rank the SM up there with the Buffet concept of “buying a dollar for 50 cents”.

Buffet says of the 50 cent dollar that people either get it or they don’t.
Same thing goes for the SM.

Ed, I look forward to meeting you this Sunday when you are in Winnipeg.

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