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Thursday, April 8, 2010

Canadian Mortgage Broker News - The tax tips (and traps) you should know now

Canadian Mortgage Broker News - The tax tips (and traps) you should know now

The tax tips (and traps) you should know now

| Tuesday, 6 April 2010

It's that time of year again - tax time. As mortgage professionals, we realize the value of a good tax accountant when it comes to planning and filing tax returns, but many homeowners tend to do a poor job of it, which can cost tens of thousands of dollars in the long term.

There are three types of homeowners, and as such, they each have their own set of tax tips. They are the
entrepreneur, the T4 investor and the Donald.

The entrepreneur
The entrepreneur is a familiar breed. Self employed by definition, entrepreneurs typically enjoy a plethora of tax benefits and write-offs. Whether they have a relatively small home-based business selling handbags on eBay, or a more established enterprise such as a lucrative consulting practice, these homeowners can benefit significantly from a multi-component mortgage that is set up to cash dam their revenue and expenses.

Cash damming is a Canada Revenue Agency-approved technique whereby a non-deductible mortgage can be aggressively converted into a tax deductible business loan to oneself. This technique is becoming more and more popular among entrepreneurs who usually seek every tax break under the law to maximize their cash flow and keep their hard-earned dollars in their own pockets.

When originating mortgages for entrepreneurs, the tip here is simple. Set up a re-advanceable line of credit with at least two components. One component is the amortizing mortgage that replaces all existing mortgage and consumer debt, the other is a line of credit to be used only for business purposes.

Most entrepreneurs understand basic cash flows: revenue comes into the business bank account as deposits, expenses go out of the business bank account using cheques. Setting up a cash dam for the mortgage in this scenario is not as complicated as one might think, and the entrepreneur just has to add two simple steps.

Firstly, before revenue is deposited to the business account, it should be applied to their mortgage as a pre-payment and then re-advanced from the line of credit using the proceeds for a "business loan" to be made from the taxpayer to themselves. This is the essence of cash damming - a very powerful strategy for the unincorporated entrepreneur and a no-risk strategy to build wealth through tax benefits (note: this does work the same for incorporated businesses, as an incorporated entity is its own "person" under tax law).

There may still be benefits to lending to your own company, but that requires a tax advice from a professional and is outside the scope of a simple cash dam that can be set up through a mortgage professional.

The Donald (Trump, that is)
The Donald is the consummate real estate investor that owns three or more properties - one of which will be the principal residence, the others all investment properties. Mortgage professionals love these clients as they are eternal optimists in the real estate market and are usually highly leveraged with mortgages on all properties.

The tax tip for the Donald who has a nondeductible mortgage on their principal residence is also to set up a cash dam, but this time it will be a special purpose vehicle. It will flow through the rental income from the investment properties as a pre-payment on the principal residence mortgage, and then re-advance the proceeds into their "landlord business" bank account from where all expenses are made.

Legitimate expenses for use of proceeds on the business loan clearly extend to mortgage interest, property taxes, insurance and management fees. However, principal payments on the investment property mortgages are not a valid expense and the Donald needs to ensure that any principal mortgage payments are funded separately and specifically not funded through the rental cash dam.

The T4 investor
This is your favourite client. These are fully qualified deals, easy to place at any lender, and the homeowner has strong credit and excellent debt-service ratios. T4 investors are also your typical Smith Maneuver and Tax-Deductible Mortgage Plan (TDMP) clients. Conventional wisdom has changed and financial advisers are increasingly advising homeowners that they can generate more wealth over the long term by investing early - long before the mortgage is paid off - as opposed to paying off the mortgage first and then starting to invest.

The definition of a T4 investor is a taxpayer with a mortgage and a J-O-B, hence the T4. Advanced mortgage strategies have gained popularity since a 2009 Supreme Court ruling effectively blessed many of these approaches including the Singleton Shuffle, the Smith Maneuver and TDMP. Furthermore, the distribution of multi-component, re-advanceable mortgages and lines of credit have made these tax strategies widely available to all qualified homeowners through their independent mortgage professionals.

Homeowners aged 35 to 55 in this category can effectively pay off their mortgages sooner and generate significant wealth through a properly managed tax-efficient mortgage plan. Since these borrowers are not self-employed or business owners, they will often be unfamiliar with the cash flow and tax issues that go along with an advanced mortgage strategy and are usually better off in a fully managed plan, where all the administration and cash management is handled on their behalf.

Tax traps: the tourist
For every great customer that can benefit from your tax advice, there is also the trap to watch out for. The tourist is the first one of these, and it's the label we apply to multiple property owners who just can't stay put, insisting on changing their principal residences to one of their investment properties. At first blush, you wouldn't see anything wrong with this, but one needs to be careful.

Take the curious case of Nina Sherle. In a landmark court decision last year, Sherle, a dual homeowner, decided to do such a move. Prior to changing her principal residence to her investment property, she enjoyed the benefits of a tax-deductible mortgage on her investment property and her principal residence was free and clear. In an attempt to keep her situation the same as she switched houses, Sherle mortgaged her current principal residence and used the proceeds to pay off the mortgage on the current rental, then moved into the current rental and legally made it her new principal residence. Sherle proceeded to rent out the old principal residence, effectively turning it into an investment property and deducted the mortgage interest as before. The desired result was to end up in the same situation - a tax-deductible mortgage on the investment property and the principal residence free and clear.

The Canada Revenue Agency reassessed Nina on the basis that "use of proceeds" of the mortgage on the investment property was ineligible and the court agreed, the moral of the story being that regardless of good intentions, the legal effect of doing this without proper planning is to make your tax-deductible mortgage no longer tax deductible. (For a full explanation of this and to learn how to avoid such scenarios, visit the "mortgage professionals" portal at

The double-dipper
This term applies to accelerated Smith Maneuver and TDMP clients. Double-dipping, as you might infer from the name, is a big no-no under Canada Revenue Agency rules. It most commonly occurs when the homeowner invests in tax-efficient mutual funds for their mortgage strategy, the most common of these known as ROC (Return Of Capital Funds). ROC investments are very popular for advanced strategies because not only is the cash flow tax-efficient, it is consistent month over month, which mitigates cash flow risk and reduces the administration required in many debt conversion strategies.

The problem is that if an investment returns capital to the investor instead of providing some form of income, there is corresponding erosion in the tax deductibility of the original investment loan that has to be dealt with properly and reported to CRA. If this ROC distribution is used to pre-pay a mortgage (before being re-advanced and re-invested), CRA has advised that, even though the monies are ultimately reinvested, the initial use of proceeds (which was to pre-pay the mortgage) is ineligible for tax deductibility.

Homeowners in managed strategy programs will be covered for this situation as the calculations and tax reporting prevents inadvertent double-dipping. However, do-it-yourself Smith Maneuver clients will rarely go the trouble of making this calculation and tend to tax deduct everything, inadvertently or intentionally. As a mortgage professional, make sure your clients double-dip at their own risk - not at yours.

While most mortgage professionals should not be putting themselves out there as tax experts, it is prudent to have a decent background and understanding of the tax implications of a mortgage transaction. All homeowners should be encouraged to employ a tax professional both in planning complex transactions and for filing tax returns. However, such advice comes at a price that may deter some borrowers. Having a keen eye on the mortgage transaction and advising customers of potential tax advantages and pitfalls is a welcome service.

- Sandy Aitken is founder and CEO of, which provides managed Smith Maneuver and
Tax-Deductible Mortgage Plan (TDMP) services to homeowners. These advanced mortgage strategies are distributed exclusively through independent mortgage professionals, and the company offers Certification training, marketing and sales support to mortgage agents through its website

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