If you have home equity, there’s a neat method to use it to make investments and write off the mortgage interest. As seen in Rew.ca.
For US homeowners, mortgage interest is automatically tax deductible, but for Canadians, the write-off is not so straightforward. However, there is a way for you to deduct your mortgage interest while increasing your wealth, an approach known as the “Smith Manoeuvre”.
In order to make your mortgage interest tax deductible, homeowners must be able to prove that the money is being reinvested and is not being used for personal expenses.
A properly structured mortgage-centric tax strategy has several key elements – the most important of which is a multi-component, mortgage or home equity line of credit (HELOC). You will need a readvanceable or line-of-credit mortgage that lets you continuously extract equity as you pay your mortgage down.
Every time you make a payment and reduce your principal, you then immediately extract that equity and add it to your investment account. Since you have been able to deduct your mortgage interest, at the end of the year you will generate a tax refund that you can use to make a lump-sum payment on your mortgage –which makes even more funds available for investment.
It’s best to have a single collateral charge with at least two components – usually a fixed-term mortgage and an open line of credit – that can track and report interest independently. This is absolutely essential under Canada Revenue Agency (CRA) rules and guidelines. In addition, for the interest payment to be tax deductible on any money borrowed for investment purposes, it must have a reasonable expectation to be able to produce an income.
Second, the strategy must employ conservative leverage-investment techniques – which is why a financial advisor must be involved in order to comply with federal regulations. The financial advisor should be a Certified Financial Planner (CFP) who is experienced in leveraged investing and able to actively monitor a homeowner’s portfolio on an ongoing basis.
Homeowners who opt for a tax-deductible mortgage interest plan make their monthly or bi-monthly mortgage payments the same way they would when making any type of mortgage payment. The payments go towards reducing the principal amount of the mortgage, creating equity; which is subsequently available to be borrowed on the line of credit. From there, the equity available in the line of credit must then be transferred to an investment account, which can be done automatically by your Certified Financial Planner.
Essentially, 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.
The Ideal Client
Ideal borrowers for an advanced mortgage and tax strategy are typically professionals or other high-income earners who have a conventional mortgage, and have at least 20 per cent of the cost of the home to put towards a down payment, or who have built up substantial equity.
As high-income earners, their total debt-servicing ratio will be quite low and they will have excellent credit (680+ Beacon scores). These borrowers are financially sophisticated homeowners that are keenly interested in establishing a secure financial future and comfortable retirement. They also have good investment knowledge.
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 should be used to pay down the mortgage as quickly as possible – thus making as much of the interest payment as possible tax deductible.
The short-term financial risk is liquidity (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.
Combining this tax deductible mortgage with a sound investment strategy can significantly increase your net worth over the long term. Talk to a mortgage expert for a free analysis of how the Smith Manoeuvre can work for you.