David Larock in Mortgages and Finance
Canadian mortgage interest can be tax deductible. Surprised? Most people I talk to about converting their mortgage to a tax deductible loan assume that a) it’s not legal b) it’s too risky and/or c) it’s too complicated. I am happy to report that none of these fears is warranted. What’s more, did you know that many Canadians could rearrange their financing today and make their mortgage interest tax-free almost immediately? So why don’t they?
My theory is that the twin causes are simply a lack of information and good-old fashioned inertia (a powerf
ul force that may be costing you thousands in tax refunds each year). Today’s post, the first of two on the topic, will lay out the facts and let you decide for yourself.
First of all, yes, it’s legal. Here is a report from the Canada Customs and Revenue Agency (CCRA) that outlines their interpretations of the deductibility of interest expense. In it, they say that if you borrow money “for the purpose of earning income from a business or property”, then the interest cost is tax deductible, provided that you have “a reasonable expectation of income at the time the investment is made”, be it in the form of interest, dividends, a combination of interest/dividends and capital gains, rents, royalties etc. The CCRA relies heavily on court decisions when formulating its policies, and here are two Supreme Court rulings in favour of the deductibility of mortgage interest, Singleton v. Canada, in 2001, and Lipson v. Canada, in 2009 (I have linked to the summaries for both cases). I say all this to reassure you that you are not testing new ground if you decide to pursue this strategy.
Keeping in mind the rules outlined above, let’s look at some examples of how a tax-deductible mortgage might be drawn up. In the simplest case, if you own a house with no mortgage on it, you would just apply for an investment loan using your house as collateral. The bank advances you the money, you invest the proceeds in appropriate assets (I strongly advise you partner with a top-tier financial planner when doing this) and when you file your taxes at the end of the year, you include the interest paid on your investment loan as a deductible expense. The amount of your refund is based on your income tax bracket so, if we assume that you paid $20,000 in interest and your marginal ta
x rate is 40%, you will receive a refund of $8,000 ($20,000 x .40 = $8,000). Of course, most people have existing mortgage loans and for this group, there are a few more steps involved.
For people with existing mortgages, the key step is converting your non-deductible mortgage debt into deductible investment debt. Again, using a simple example, let’s assume that you have a readvanceable mortgage (which allows you to borrow back the full loan amount at any time) of $300,000 and investments of $300,000. You could sell your investments, pay off the mortgage, reborrow the $300,000 back the next day, and then repurchase the same investments thirty days later (in accordance with CCRA rules). While you still have a $300,000 loan secured against your house and a $300,000 investment portfolio, your interest is now tax-deductible. Everything is the same, except for the large refund cheque you get from the government each April. If we assume that your marginal tax rate is 40%, and that your $300,000 mortgage is financed with a 5% interest rate amortized over 25 years, your first-year tax refund would be $5,882 ($14,706 x .40 = $5,882).
(In the example above, you want to make sure that selling your investments doesn't trigger capital gains tax that you could otherwise delay. If you are not sure how to go about this, seek advice from a qualified financial planner. You may find that now is a good time to employ this strategy because with the recent weak performance of the markets, many portfolios may have more capital losses than gains. Triggering these losses could be very useful for several other reasons as well, although that analysis is beyond the scope of this mortgage-oriented article.)
Continue reading "How to Make Your Mortgage Tax-deductible (Part One)" »
