Tax Deductible Mortgages / Debt

by Mr. Cheap

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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