The biggest loan most of us will ever have is the mortgage. In the United States, interest on mortgage loans is tax deductible, but in Canada it is not. However, investment loans are tax deductible, and there are ways to take advantage of this. Read on for details...
Interest on Investment Loans
When the government wants to encourage something, it often gives a tax break or subsidy. The government wants to encourage investment, so the interest on loans that are taken out for the purpose of investments is tax deductible. The idea is that the investment is supposed to generate some sort of income, which will then be taxed, and you pay the tax on the difference of the investment income and the interest expense. For example, with a rental property you can deduct the interest.
An obvious example of an investment loan is borrowing money to run a business. Another is when you own a rental property - the mortgage interest is considered an expense of the rental property and is tax deductible. Finally, borrowing money to buy equities is considered an investment, so again the interest would be tax deductible.
When you borrow money to buy a principal residence, this isn't considered an investment (however, in Canada, you don't pay capital gains when you sell your principal residence, unlike in the United States). What this means is that when paying off a $300,000 mortgage, you will likely pay about $300,000 in interest, and therefore need to earn about a million pre-tax dollars to pay for the mortgage principal, mortgage interest, and the taxes on the income itself.
The Smith Manoeuvre
In his book, Fraser Smith explains how to convert your non-tax-deductible conventional mortgage to a tax-deductible investment loan. In a nutshell, assume you borrowed a certain amount, say $300,000, as leverage to buy your principal residence. As you pay down the principal, you re-borrow the money to invest. If there is any extra money that you would normally invest in a taxable account, you first commit to paying down your mortgage, and then immediately re-borrow that money to invest.
This is essentially tax arbitrage, but it doesn't let you come out ahead at the interest rates available today. A 5-year variable rate mortgage can be currently obtained at around 2.00%. Now that the Bank of Canada has lowered its prime rate, home equity line of credits are available at rates of around 3.35%. If you are in the 40% tax bracket, the 2.00% post-tax rate is equal to 3.33% pre-tax, almost equivalent to the home equity line of credit rate.
If you are already leveraged (or are trading on margin), employing the Smith Manoeuvre likely allows you to obtain the leverage cheaper than using the margin account at a broker. However, if you were considering the Smith Manoeuvre for tax benefits, there aren't any substantial benefits today.
Please contact us if you have any additional questions about this technique.