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Ask RK: 3 strategies to create a tax-deductible mortgage in Canada

Tax refund tax deductions tax deductible mortgage

Q: A reader wants to know if there is any way to convert a principal residence mortgage into tax-deductible debt. 

My partner and I are passionate about real estate and avidly follow your insightful posts and columns.

I was wondering if you know of any strategies to solve our mortgage interest deduction dilemma. 

We own two houses, both fully paid and no debt. Property A is our principal residence; property B is an investment property. Recently we added to our real estate portfolio by buying property C.

The plan is to take out a mortgage on property C and move into this property as our new principal residence. We would then turn property A into a rental property. Unfortunately, we know that the interest paid on the mortgage we take out on our new principal residence will not be tax-deductible. 

Are there any strategies that we can adopt so that we can turn this non-deductible debt into a tax-deductible debt? 

Thanks

M

A: Here’s how Canadian homeowners can turn their principal residence mortgage into a tax-deductible debt

First, thanks for buttering me up. It’s lovely to hear that even after taking a bit of a hiatus from column-writing and answering reader questions, people still find my previous articles and answers to real estate questions, still informative. 

Your question touches on the aspect of real estate investing that I love: strategies for increasing overall net worth using real estate. 

In personal finance, quite often we consider each decision in isolation. Not only is this a mistake, but it prevents us from understanding the more complex, but potentially beneficial strategies open to us. That’s why I love your question: You realize that taxation — and not just the acquisition of assets and paying down debt — is an integral part of wealth-building.

So here’s my answer: You can turn your principal residence mortgage into a tax-deductible debt, but it takes planning and a committment to rethink how to use debt in building your net worth. 

Why we need to classify debt

Women-paperwork-debt-calculator

While we are all taught that debt is bad, the fact is it’s really not that simple. Nor should it be. 

At the risk of keeping it still too simple, debt can be divided into two broad categories: 

  • Good debt is debt that helps you earn or allows you to reduce your taxes on what you earn. For example, a low-interest loan that is used to invest in an ETF index portfolio with a high rate of return. 
  • Bad debt is money owed on a good or service that doesn’t earn you money and can’t be considered a tax-deductible expense. For example, a loan that is taken out to buy a boat, assuming you won’t be using this boat for commercial purposes.

(For help on how to classify debt as good, bad or a mix of both, read Robert Brown’s excellent article on the topic.)

How does this apply to a non-tax-deductible Canadian mortgage?

A mortgage against a principal residence and the interest paid on that mortgage is not tax-deductible. (In America, the interest paid on a mortgage even on a principal residence, is a tax-deductible expense.)

Yet, a mortgage on a rental property is a tax-deductible debt — meaning you can deduct the interest you play on that loan to reduce the overall income tax you owe. 

If your criteria for assessing good and bad debt were the only factor, then:

  • a loan on a principal residence is bad, good debt = bad because you can’t deduct the borrowing costs, but good because it’s used to leverage your purchasing power of a high-value asset;
  • whereas a loan on a rental property is good, good debt = good because the mortgage interest is tax-deductible and good because the money is being used it’s used to leverage your purchasing power of a high-value asset;

Why not take out a mortgage on the rental property and use it to purchase the principal residence?

Logically, then, wouldn’t it make sense to take out the mortgage on the rental property, use the rental income to pay down the mortgage and use the loan as a down payment (or a cash purchase) on your principal residence?

No, because the use of the loan money does not meet the Canada Revenue Agency’s rule about how borrowed money can be spent in order for the interest on that loan to qualify as a tax-deductible expense.

According to the CRA:

  • If you borrow money to purchase an income-producing asset, the loan interest is a tax deduction.
  • If you borrow money to purchase a non-income-producing asset, such as a home you intend to live in, the loan interest is not a tax deduction.

Does this mean you’re stuck with a large, non-tax-deductible debt? Not necessarily.

Here are three strategies to create a tax-deductible mortgage loan taken out against your principal residence.

Strategy 1:  Create a tax-deductible mortgage through the Smith Manoeuvre

Tax deductible mortage mortage interest

One method of creating a tax-deductible mortgage is to reposition the borrowed money so that it’s used to purchase an income-producing asset. 

This method was first developed by a B.C.-based (and now retired) financial planner, Fraser Smith. He reasoned that any Canadian could convert their non-tax-deductible home mortgage into a tax-deductible investment loan.

The basic of the Smith Manoeuvre

Paid-Off House: If the mortgage on your home is paid off, this strategy is relatively simple.

First, get a mortgage on the paid-off home. Then use this money to purchase investments (such as rental properties, stocks, bonds, ETFs and mutual funds). As long as the money is used to purchase investment assets, the interest on that loan is tax-deductible.

The idea is that you borrow money at a cheap rate — say 3% or 4% — and invest that money based on an earnings assumption that is at a higher rate, say 5% to 7%, or more.

Every month you pay your mortgage, but come tax time, the interest on that mortgage is a tax-deductible expense.

Large Investment Portfolio: The strategy also works for homeowners who have not paid off their mortgage but have a sizeable investment portfolio already saved and invested.

In this situation, the homeowner liquidates her portfolio then uses the money to pay off the home mortgage; she then takes out a mortgage on the home and uses that money to re-purchase the portfolio (or reinvest, based on her financial plan).

In this way, the homeowner has created a tax-deductible expense, using a mortgage loan.

Strategy 2:  Create a tax-deductible mortgage through debt-conversion

mortgage deferral options credit crunch using loans cash on a rope

However, not all homeowners are fortunate enough to have a paid-off home or a large investment portfolio. If this is your situation, your strategy is going to look a bit different. 

Continue to get a mortgage to purchase your principal residence. While you’ll still want to shop around for the best rates and terms, you’ll also want to find a lender who is willing to offer you a collateral mortgage.

A collateral mortgage is a revolving line of credit that is secured against your home. Each time you make a payment a portion goes to reduce your overall debt (the principal) and that portion then becomes available for you to borrow.

To help explain, let’s consider an example. 

Let’s assume you have a $500,000 mortgage, but your home is worth $750,000. At an interest rate of 3% on a mortgage amortized over 25 years, your monthly mortgage payment is $2,371 — $1,234 of that payment is interest and $1,137 goes towards the principal. That means that with each mortgage payment you reduce your debt by $1,137. (We aren’t factoring in how the portion between principal and interest changes over time.)

Now, to convert the non-tax-deductible loan into a tax-deductible debt, you will borrow back the money you paid — in this case, $1,137 — and use that to purchase investment assets (such as stocks, bonds, GICs, ETFs, among others).

Your total debt remains the same — pay $1,137 then borrow $1,137 — but now the interest is tax-deductible.  

Over time, what you owe on debt that doesn’t qualify for a tax deduction will decrease, while the loan used for investment purposes, and the portion of interest on this loan, increases. 

Repeat this process and, over time, you convert a non-tax-deductible debt into a tax-deductible expense. 

A fully tax-deductible mortgage is achieved once your principal residence mortgage is completely paid off (although, you will still have an outstanding investment loan). 

To make debt-conversion you need to understand the risks

Since you don’t have to pay off your mortgage to implement this strategy, virtually any homeowner can use the debt-conversion strategy. 

Just be sure you understand the downside to this strategy. 

Perhaps the biggest risk is the potential to magnify your losses. Leverage works because it allows you to multiply your buying power; you purchase a high-value asset by using a small percentage of your own money and a large percentage of the lender’s money.

To help illustrate, let’s say a buyer purchases a condo for $250,000 with a $50,000 down payment. Over the next five years, the value of the condo increases to $332,500, at which point the condo owner sells the unit. In simple math, the condo owner earned a 33% return on the initial purchase. But that’s not entirely accurate since the buyer didn’t purchase the condo outright, but leveraged a smaller portion of their own money to purchase this higher-value asset. Assuming the profit from the sale was $82,500 (sale price, minus mortgage costs) then the condo owner would’ve earned $32,500 on their original investment of $50,000. That’s a 65% return. Of course, you’d still have all of the transactional costs involved in buying and selling so you wouldn’t get the full 65% return, but it’s a good illustration of how leverage works.

But the opposite is also true when it comes to losses.

What if the condo dropped in value by $50,000 just before the owner sold? A sale price of $200,000 would mean the owner wouldn’t get the $50,000 down payment back. Worse, they’d also owe the bank an extra $50,000 — the shortfall between the sale price and what’s owed to the bank (this is simple math, so we’re not including transactional costs or calculating exact mortgage numbers). In this case, the use of leverage means that while the investment declined in value by just 20%, the buyer’s losses are 100%.

Then, there’s the hurdle of overcoming the psychological aversion to debt, particularly if you fear the investment portfolio won’t or can’t provide the expected returns. 

Finally, there’s a risk that you will disqualify your investment loan and be denied the tax-deduction.

According to the CRA, if you borrow money and claim the interest as a tax deduction, that money must be used to purchase an income-producing asset. According to the CRA  Interpretation Bulletin, IT-533: 

“…the test to be applied is the direct use of the borrowed money.”

To put it bluntly, you cannot use the money for anything else; you can only use it for investment purposes. And the onus is on you to prove the case. You must provide a paper-trail — evidence that every dollar spent was used in accordance with the CRA rule

The easiest way to do this is to never use the equity in your home for anything other than purchasing income-producing investments. Don’t buy a boat; don’t spend it on a vacation, and don’t use it to renovate your home. 

If you do intend to use borrowed equity from your principal residence for any purpose other than for investments, be sure to sever this amount completely and keep all documentation to show that separation. (A great way to do this is to use a collateral mortgage that allows you to hive off segments into different accounts. Just be sure you only claim the interest paid on the line of credit that is used for investing.)

In this way, a debt-conversion strategy is a powerful tool. Not only does it prompt a homeowner to focus on repaying their mortgage debt it also provides a homeowner with an opportunity to invest money earlier, which allows you to take advantage of longer investment timelines and the power of compound interest. 

Strategy 3: Create a tax-deductible mortgage using a promissory note and a deemed disposition

House for rent

There is one final option, but it does require the use of a trustworthy family member (or friend) as well as the desire to turn your home into a rental property. 

This is how it works: 

Day #1. Sell your current home to a family member at fair market value.

Rather than take out a loan that family member pays for the purchase by issuing a promissory note.

To stay on the right side of the CRA, make sure each portion of this step is properly documented and legally authorized, ie: get the promissory note notarized. (A document is notarized when a third party, either a lawyer, paralegal or notary public, verifies identities, witnesses the signing of the document and, in some cases, requires the parties in the agreement to swear or affirm that the facts in the document are true.) 

Day #2. Reacquire your ‘old home’ from your family member. 

Now, repurchase your home from your family member. Do this by getting a mortgage on the home.

Give the family member the money obtained from this mortgage. Don’t forget to legally document this transaction (use a Purchase & Sale agreement; work with a legal representative, etc.)

Day #3. Your family member pays off that promissory note.

This is when your family member uses the money that was given to them — the money from the mortgage you obtained — and pays the money promised to you (remember that promissory note).   

Day #4. Purchase your new principal residence.

Take the money you’ve obtained from the repayment of the promissory note and use it as a down payment (or a cash purchase) of your new principal residence.

Because the mortgage you obtained on Day #2 was for the purchase of a rental property, the interest on the mortgage is tax-deductible (and used to offset the rental income collected and reported).

The result: You now own a rental property, using a tax-deductible mortgage and you just purchased your new principal residence.

Final thoughts

Please understand that any information contained in this answer should not be considered advice. I am not a financial planner and do not profess to have all the facts of a reader’s situation. The information contained in this Ask RK column is meant to be informative only. I strongly advocate paying for professional advice. A good financial planner can advise you on the pros and cons of these leverage strategies, along with the risks; a legal representative or tax expert familiar with these strategies may cost a bit upfront but will save you tens of thousands (or more) in the long-run. 

Image of Romana King

Romana King

Romana King is an award-winning personal finance writer, real estate expert and the current Director of Content at Zolo. Romana has contributed to business and lifestyle publications including CBC.ca, Toronto Sun, Maclean’s, MoneySense, Globe & Mail Custom Content Team, and The Toronto Star. Among her achievements, Romana won silver for her annual Where to Buy Now real estate package in the 2019 Canadian Online Publishing Awards. In 2015, she won a SABEW Business Journalism award. When she was editor of CI Top Broker, Romana helped guide her team to obtain its first KRW Business Journalism nomination, and in 2011, she was part of a small team that helped MoneySense win Magazine of the Year at the 34th annual National Magazine Awards.