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How to Make Your Mortgage Tax-deductible (Part One)

Last Updated on November 10th, 2017

by David Larock

Canadian mortgage interest can be tax deductible. Surprised? Most people I talk to about converting their mortgage to a tax deductible loan assume that a) it’s not legal b) it’s too risky and/or c) it’s too complicated. I am happy to report that none of these fears is warranted. What’s more, did you know that many Canadians could rearrange their financing today and make their mortgage interest tax-free almost immediately? So why don’t they? My theory is that the twin causes are simply a lack of information and good-old fashioned inertia (a powerftoronto mortgage ratesul force that may be costing you thousands in tax refunds each year). Today’s post, the first of two on the topic, will lay out the facts and let you decide for yourself.

First of all, yes, it’s legal. Here is a report from the Canada Customs and Revenue Agency (CCRA) that outlines their interpretations of the deductibility of interest expense. In it, they say that if you borrow money “for the purpose of earning income from a business or property”, then the interest cost is tax deductible, provided that you have “a reasonable expectation of income at the time the investment is made”, be it in the form of interest, dividends, a combination of interest/dividends and capital gains, rents, royalties etc. The CCRA relies heavily on court decisions when formulating its policies, and here are two Supreme Court rulings in favour of the deductibility of mortgage interest, Singleton v. Canada, in 2001, and Lipson v. Canada, in 2009 (I have linked to the summaries for both cases). I say all this to reassure you that you are not testing new ground if you decide to pursue this strategy.

Keeping in mind the rules outlined above, let’s look at some examples of how a tax-deductible mortgage might be drawn up. In the simplest case, if you own a house with no mortgage on it, you would just apply for an investment loan using your house as collateral. The bank advances you the money, you invest the proceeds in appropriate assets (I strongly advise you partner with a top-tier financial planner when doing this) and when you file your taxes at the end of the year, you include the interest paid on your investment loan as a deductible expense. The amount of your refund is based on your income tax bracket so, if we assume that you paid $20,000 in interest and your marginal tacanada mortgage ratesx rate is 40%, you will receive a refund of $8,000 ($20,000 x .40 = $8,000). Of course, most people have existing mortgage loans and for this group, there are a few more steps involved.

For people with existing mortgages, the key step is converting your non-deductible mortgage debt into deductible investment debt. Again, using a simple example, let’s assume that you have a readvanceable mortgage (which allows you to borrow back the full loan amount at any time) of $300,000 and investments of $300,000. You could sell your investments, pay off the mortgage, reborrow the $300,000 back the next day, and then repurchase the same investments thirty days later (in accordance with CCRA rules). While you still have a $300,000 loan secured against your house and a $300,000 investment portfolio, your interest is now tax-deductible. Everything is the same, except for the large refund cheque you get from the government each April. If we assume that your marginal tax rate is 40%, and that your $300,000 mortgage is financed with a 5% interest rate amortized over 25 years, your first-year tax refund would be $5,882 ($14,706 x .40 = $5,882).

(In the example above, you want to make sure that selling your investments doesn’t trigger capital gains tax that you could otherwise delay. If you are not sure how to go about this, seek advice from a qualified financial planner. You may find that now is a good time to employ this strategy because with the recent weak performance of the markets, many portfolios may have more capital losses than gains. Triggering these losses could be very useful for several other reasons as well, although that analysis is beyond the scope of this mortgage-oriented article.)

In the two examples I’ve given so far, I have assumed that you either own your home outright or have a substantial investment portfolio. But fear not, for those of us with no investments and at least 20% equity in our homes, there is still hope thanks to a retired financial planner named Fraser Smith, a pioneer whom mortgagors enjoying tax-deductible interest should toast when their refund cheques arrive. In his book, called “The Smith Manoeuvre”, Fraser explains how we can convert our existing mortgage debt into deductible debt over time, without borrowing more money to do it. Basically you need a mortgage combined with a good readvanceable line of credit (check out my post for full details on how these work). The key feature of a good readvanceable is that every time you pay down your mortgage principal, your line-of-credit-limit increases by the same amount, so you can immediately borrow back the portion of each payment that goes toward principal and invest it instead. Over time, as your mortgage shrinks, your line of credit and investmmortgage broker torontoent equity grow by the same amount, gradually converting your loan from non-deductible mortgage debt to deductible investment debt. If you use your annual tax refunds to further reduce your mortgage, you can accelerate this process even more. (Note: To keep your conversion process totally cash neutral, each time you borrow back your paid-down principal, you should pay the interest on the line of credit first, and then invest the remainder.)

There is another significant advantage to this strategy. Most Canadians plan to pay off their mortgage first and then build an investment portfolio. But it takes a long time to pay off so much debt, and the earlier you invest, the longer you can enjoy the effects of compounding (which is the real magic in investing). In his book, Fraser Smith writes that  “two-thirds of the effect comes from the benefits of owning your investments now instead of later. About one-third of the benefit is the effect of converting to tax deductible interest.” Instead of building equity in your home and paying non-deductible interest, you are building equity in your investment portfolio, paying deductible interest and investing the tax refunds. While it’s true that in the latter scenario you are not retiring your overall debt, you are transferring a portion of your home equity to diversified investments. If at some point you want to decrease your overall debt level and reverse part or all of this strategy, you can simply sell some or all of your investments and use the money to pay down your mortgage.

Today we’ve addressed the basic legal situation and explained thbest mortgage rates torontoe mechanics of how a tax-deductible mortgage can be set up. Next week I owe you my quarterly Mortgage Market Update, so the following week we’ll return to this topic. In Part Two, I will address some of the most common questions people have about making their mortgage tax-deductible, and provide some examples of borrowers who are well suited to consider this option. Stay tuned!

(Please Note:  You should not make any changes that affect your tax status without obtaining tax advice from a certified financial planner, accountant, or lawyer. I can explain the concepts, point you in the right direction and provide the appropriate mortgage terms, but I am not a licensed tax practitioner.)

David Larock is an independent full-time mortgage broker and industry insider who helps Canadians from coast to coast. If you are purchasing, refinancing or renewing your mortgage, contact Dave or apply for a Mortgage Check-up to obtain the best available rates and terms.
64 Comments
  1. John permalink

    Hi David,
    After reading the comments I have a situation that maybe you can shed some light on.
    So I have a home that is mortgage free. I want a new house but I want to keep my current home and use it as a rental property. Even if I mortgage my current home to buy the new house that I want to live in, the interest won’t be tax deductible.
    What about if I were to sell the current house to my parents for FMV and they pay for it by issuing a promissory note payable to me. The next day I go to the bank and secure a mortgage and use the funds to purchase back the home from my parents. My parents then use the funds they received to repay the promissory note that was issued to me. I then take that money and purchase my new principal residence.
    What are your thoughts on that?
    Thanks,
    John

  2. Hi John,

    Interesting thought but this approach would cost the earth in land-transfer taxes (which your parents would have to pay if they bought the property from you, and you would pay again if you bought it back from them).

    In the end, the land transfer taxes would be many, many times more than any saving you would realize by making your mortgage interest tax deductible (and that assumes that you this would pass a CRA smell test as well!)

    Best regards,
    Dave

  3. John permalink

    Hi Dave,

    This situation is happening in Alberta, and it is my understanding that there are no significant land transfer taxes here. We have a land transfer fee with 2 portions, one on the property value and the other on the mortgage value, both with a base of $50 plus $1 for every $5,000 portion of the value of each. For example on a $500,000 home the fees would be less than $300. Would this make this option more viable?
    Thanks,

    John

  4. Hi John,

    Thanks for clarifying. If the land transfer taxes are not significant that would certainly lower the transaction costs but I’m still not sure if this would pass the smell test with CRA because it can always invoke the “general tax avoidance” clause even if your approach technically conforms with the tax rules as written.

    That said, I recommend that you run your idea by an accountant. If you can circle back after I would love to close the loop on what he/she said!

    Best,
    Dave

  5. Anjan Saha permalink

    I have mortgage for my primary residence home i.e. 125,000.00. I did refinance and got $660,000.0. I invested in rental house for $660,000.00

    My question is am I be able to deduction interest expense for 660K-125K

  6. Hi Anjan,

    Yes on the $660k (because you used those funds to purchase the investment property), but no on the $125k (because you used those funds to buy your principal residence).

    Best.
    Dave

  7. Hi there. For a first time home buyer, can you claim the interest on mortgage payments on income tax? The house was bought 6 years ago. Thanks

  8. Hi Bonnie,

    If your mortgage was used to finance the purchase of your principal residence then there is no way to make the interest tax deductible.

    Best,
    Dave

  9. Hi David, I have a principle home with very little mortgage left. I have a HELOC on this principle house. I have used some money from the HELOC towards down payment of a rental property. Currently I have some cash. Which is better to pay of mortgage left on my principle property or pay of the money I have borrowed from the HELOC. Thanks

  10. Hi Jan,

    The interest cost on the money that went toward your rental property is tax deductible, whereas the interest cost on the money that was used to purchase your principal residence is not.

    Given that, my advice would be to pay off the mortgage portion of this loan first.

    Best,
    Dave

  11. Stacy Norman permalink

    My mortgage is paid off, could I just use my existing Homeline plan to purchase a rental property and write the interest off or do I need to get a specific business loan for the property?

  12. Hi Stacy,

    You should be able to write-off the interest if you use your existing Homeline to purchase a rental property. (FYI – You don’t need a special type of loan in order to qualify under CRA’s rules.)

    Best,
    Dave

  13. Manoj Dangwal permalink

    Hi Dave,

    My primary residence has 450,000 mortgage on it and I have a rental property on which I have an equity of 280,000. I can probably get $220 K (80% of 280,000) as equity loan from my rental property.

    I am thinking of using this $60 K for making 15% lumpsum annual payment to my primary mortgage and use rest $160 K for investing .

    Is the interest part on the equity loan that I am planning to take out of rental property tax deductable?

  14. Hi Manoj,

    The test determine whether the interest cost on the additional funds you are borrowing is tax deductible is what the funds were used for.

    In the scenario you describe, the interest on the $160k you borrow to invest should be tax deductible provided that you purchase eligible investments (see my post for more details on eligible investments and talk to your financial planner), and the interest on the $60k would not be tax deductible because you would be putting that money toward the mortgage on your principal residence.

    Best,
    Dave

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