Well aren’t they lucky. Mortgage interest is automatically tax deductible for US home owners. Unfortunately, in Canada, it’s not so easy. In order to make your mortgage interest tax deductible, Canadian homeowners must prove that their money is being reinvested, and not being used for personal expenses.
A properly structured mortgage-centric tax strategy has several key elements, most important of which is a multi-component, re-advanceable mortgage or line of credit.
You should have a single collateral charge with at least two main components:
- A fixed term mortgage
- An open Line of Credit that tracks and will report interest independently.
This is a must under Canada Revenue Agency (CRA) rules and guidelines.
Next, your strategy must employ conservative leverage-investment techniques, and a financial advisor must be involved in order to comply with federal regulations. Look for a financial advisor who has his Certified Financial Planner (CFP) designation, experienced in leveraged investing, and able to actively monitor your portfolio constantly.
Game plan
Continue to make your mortgage payments as you normally would. Your payment goes towards reducing the principal amount of the mortgage, and is then transferred to the line of credit as the mortgage is paid down. The next step, and the essential piece in order to make your payment tax-deductible, is to have the funds transferred to an investment bank account. This can be done automatically by your financial planner.
Once your money is in an investment bank account, it can be reinvested, and the money becomes tax deductible. The homeowner is borrowing from the paid portion of the mortgage for reinvestment purposes.
On average, a typical 25-year mortgage can become fully tax deductible in 22.5 years.
Rental Property
If you own a rental property, you may also use this tax-reduction strategy. When you collect rent, use the funds to pay down your personal mortgage. The rental funds move to the line of credit, and are then transferred to the investment bank account. Those funds are now used to pay down the mortgage on the rental property. Using this method, it’s possible to have your mortgage interest fully tax deductible in 3.5 years.
The ideal client
Ideal borrowers for this type of strategy are typically professionals or other high-income earners who have a conventional mortgage (20%+ down payment) and have built up substantial equity.
As high-income earners, their total debt-servicing ratio is quite low, and they’ll have excellent credit. These borrowers are financially sophisticated homeowners, and are interested in establishing a secure financial future, and comfortable retirement. They’ll also have good investment knowledge.
The risks
The financial benefits of tax-deductible mortgage interest are indisputable and justify the risks to the right borrower. That said, a problem can arise if a homeowner spends the funds as opposed to reinvesting them. As well, any tax refunds have to flow through the investment cycle in order to realize the benefits of paying down the mortgage as quickly as possible – and making as much of the interest payment as possible tax deductible.
Short-term financial risk is liquidity risk (sometimes referred to as cash flow risk). Cash flow risk addresses the possibility that interest rates will sharply drive up the cost of borrowing at the same time as markets falter, resulting in a negative client monthly cash flow for a brief period of time.
This short-term risk is typically only prevalent in the first two to four years because, after this period of time, the homeowner has stockpiled enough equity through annual tax refunds that other liquidity options exist, and the risk is fully mitigated.
Liquidity risk varies widely based on the balance sheet strength of the homeowner. Highly qualified homeowners are easy to manage as these borrowers have no difficulty meeting the short-term cash flow demand should the need arise.
Feel free to give me a call if you think this strategy is right for you, and you would like to discuss switching into a mortgage product that gives you access to a secured Line of Credit.
Have a great day!