Western economies are susceptible to recessions approximately every 15 years. While most Canadians will never face a bigger debt in their lifetime than their mortgage payment which can span over a 20 to 25 year period, they are rarely provided with strategies that will lessen this burden. As economic times change from good to recession and back to a strong recovery again, the debt load of the Canadian property owner is always present. Currently 3.5 million mortgages in Canada are non tax-deductible. The question that many Canadians ask themselves and their trusted advisors is:
“Does it have to always be this way?”
The quick answer is no. To take advantage of mortgage debt and find tax relief, the mortgagor can turn Lemons into Lemonade by taking control of their financial situation. One control method which is fully tax deductible is to write-off mortgage interest as an investment expense. Few Canadians know or understand how to leverage this Canadian tax strategy which is readily available and can increase ones net worth (return on equity) and save thousands of dollars, while shaving years off their mortgage payments.
The typical mortgage strategy concept on its own is a very simple one, but the knowledge and tools require a sophisticated understanding of how to take advantage of a number of tax saving dollar strategies. What clients want today is a road map that will maximize their financial resources. Unfortunately the advice they receive only applies to one area of their financial life at a time - be it tax planning, investment management, insurance or what ever else. Rarely is a multiple disciplinary approach taken. Thus, allowing the individual to combine multiple strategies together to gain maximum results by implementing a solution that addresses the client’s essential needs.
Today’s savvy clients are demanding from their advisors a more blended tax saving planned approach. This approach not only will increase personal profits while lowering expenses, but further allows a client to utilize all their assets. Getting more out of every dollar is the ultimate end game. Mortgage interest deductibility provides this additional benefit of holding an investment portfolio while owning a home simultaneously.
How does this work?
This strategy requires clients to sell off their non-registered investment portfolios to pay off or pay down their mortgages and then borrow the equal amount again for the purpose to invest. The client’s debt does not increase, but this debt conversion process allows the client to turn non-deductible mortgage payments into deductible interest payments. Resulting in the interest caring cost from a traditional mortgage to be reduced by a client’s marginal tax rate.
This concept allows the mortgagor to save upwards of hundreds of thousands of dollars in interest payments and years off their mortgage, while placing their hard earn money back in their pocket where it belongs.
By looking at the following example one can see how tying a mortgage to an investment portfolio offers the best tax savings road map a savvy investor would want to utilize.
Let us imagine Client A invested $200,000 into his portfolio, and his shares have dropped in value. Today Client A’s investment portfolio is now worth $150,000 due the market decline which created a paper loss of $50,000.
Client A also holds a mortgage for $150,000 and is paying 5% per year or $7,500 after tax interest. If Client A is in a 46% marginal tax bracket it actually costs him $13,889 of pre-tax income to pay the $7,500 interest cost after tax per year. By selling off his $150,000 investment portfolio using these funds to pay down his mortgage and then turning around and borrowing $150,000 to re-invest, Client A’ will save $6,389 per year in tax dollars. This occurs because the mortgage is for now investments purposes so it becomes a write- off for the interest paid on the $150,000. Now the loan for Canadian Revenue Agency purposes has been reclassified from being a mortgage to an investment loan.
Now let’s look forward at Client A. He re-invests in the same investment portfolio as before using a 6% rate of return compounded over 5 years, the $150,000 grows to $200,734 and earns back $50,734 which he lost on paper when the investment markets went down.
For this example, lets round the figure off to $50,000. Now let’s assume Client A sells his investments and receives a $50,000 capital gain, which is written off against the $50,000 capital loss he took five years earlier. It’s at this moment, Client A receives a 23% tax savings or $11,500 which would have had to been paid as his capital gains tax on the $50,000 to CRA.
Lets assume that Client A invests his entire $6,389 of the tax savings from restructuring his mortgage to an investment loan into his RRSP and it earns him 6% compound yearly for 5 years. Client A will have invested $31,945 of his tax savings into his RRSP during this period which will have earned an additional $6,231 to a total value of $38,176 at the end of the 5 year period.
If we sum up the two savings together ($38,176 + $11,500), this individual is wealthier utilizing the portfolio / mortgage strategy by $49,676. These savings would not have been possible if he had not combined these strategies of realizing his capital loss on his portfolio, making his interest on his mortgage deductible and re-investing the tax saving in his RRSP.
By implementing this model, all of us can create a worthwhile tax saving plan while becoming mortgage debt free sooner then the traditional mortgage routes available. Obviously, this approach requires a specialty in areas such as accounting, mortgages evaluation, investment management, and tax. Many clients and their accounting professionals will need to seek educational services to aid them in the setup and maintenance stages. Therefore, it is worth the time and money to hire the right professional consultants to assist in the design, implementation and maintenance of this solution.
Peter J. Merrick, BA, FMA, CFP,TEP, FCSI