How to turn your mortgage into a tax advantage

Unlike our neighbours to the south, mortgage interest on a principal residence in Canada is not tax deductible, well, at least not without some elaborate tax planning.

With some careful structuring, Canadians can actually take advantage of preferential interest rates available to them by leveraging their homes, while at the same time obtaining a tax advantage.

It’s important, however, to avoid the many tax pitfalls inherent in this sort of strategy. Below are a few of them.

The right and wrong way to deduct mortgage interest on a rental property

Many investors believe that it’s a straightforward equation: take a mortgage on your rental property then claim the mortgage interest as a deduction against the rental revenue.

A common misunderstanding is that securing the mortgage to an investment property is the precondition allowing the interest deduction. Nothing could be further from the truth. It is not the asset used to secure the loan, but rather the use of the money borrowed which enables a taxpayer to take a deduction on the interest paid.

For example, say you were to re-finance your rental property, then take the extra money to put a downpayment on a new cottage (for personal use). The additional interest associated with the inflated mortgage would not be tax deductible because the money was used to purchase an asset for personal use. If the additional financing were used to repair, maintain, or improve the actual rental property then the argument for deduction would exist.

The right and wrong way to take a mortgage on a personal home to invest

Many homeowners attempt the “Smith Manoeuvre”– the name of an investment strategy coined by financial author Fraser Smith – whereby an individual secures a loan, such as a Home Equity Line of Credit, against the equity of their house, then uses the additional funds to finance a variety of investments. One must carefully monitor the structures of these investments to ensure that the interest is indeed tax-deductible.

One of the conditions is that the investments must at least have the potential to pay income as opposed to only exempt income or capital gains. A stock trading on a major exchange can produce both a dividend and a potential capital gain much in the same manner that a rental property can produce both a stream of rental income and a capital gain on sale.

Gold bullion, on the other hand, will never pay interest, dividends or rent, and under normal circumstances will only produce a capital gain for tax purposes. Therefore, a leveraged investment in pure gold (or silver, or nickel for that matter) would not normally qualify you to deduct your interest.

The right and wrong way to reshuffle your finances

It’s wise to take a financial snapshot of your assets and liabilities to see if tax planning opportunities exist. In many cases families can make a simple shuffle in their finances to re-organize tax-inefficient debt into tax-efficient mortgages.

A classic example would be a family with a sizable investment portfolio outside of an RRSP and a mortgaged family cottage. The investment portfolio pays dividends and interest both attracting tax, whereas the interest payments on the personal-use cottage provides no tax benefits whatsoever. Instead the family should have liquidated their portfolio, bought the cottage, then refinanced and invested in a new portfolio.

If structured properly, the once tax-inefficient mortgage becomes a tax-efficient investment loan – all the while leaving the family in the same net financial position.