Budgeting for a Mortgage
September 22, 2010Fall Mortgage Market Update (2010)
October 6, 2010Canadian 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 powerf
ul 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 ta
x 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 investm
ent 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 th
e 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.)
68 Comments
Great post David!
I’d like to add a few more pointers
Things you need first…
High tax bracket
Stable job
Disability coverage.. (coverage at work is too weak)
Life insurance…if you are going in debt…you need more
Able to max out on the TFSA every year!
What you want/should consider to buy…
Conservative investments… at least 30 to 40% in bonds!!
Taxes… pay little or no taxes untill you sell!
Dave, you ROCK! Thanks very much!
This is a fantastic article. i have been looking for CRA ruling. I was never sure of the scope of investments such as bonds and stocks.
Thanks for this info. I have a question. If I borrow money from my home equity line of credit (HELOC) and invest it in MUTUAL FUNDS (as opposed to cashflow-generating investments), would the HELOC interest payments be tax deductible?
Hi Moncia,
In theory mutual funds should be eligible but it comes down to their specific characteristics (for example, do they pay dividends or do they at least have the realistic prospect of paying dividends?)
The best way to be sure is to ask your financial advisor or your accountant.
Best,
Dave
This is a very important column for anyone considering a mortgage refinance especially cashout mortgage refinance.
If the HELOC is used to invest in real estate in Toronto, more specifically condos, will this be applied to tax-deductible?
Thanks!
Hi Daniel,
If the HELOC funds are used to purchase an investment property then the interest cost would be deductible against the rental income you receive for that same property.
Dave
Hi Dave,
Really enjoyed your article. I’m trying to decide whether to claim the interest on a rental property I own and had a question about tax implications when selling and investment property:
If I was using one of the tax-deductible mortgage interest strategies that you mentioned, on a property that I purchased for 100K, and if I assume that the property value does not increase over time for this example, what capital gains tax might I have to pay when I sold the property for 100K? Would I be taxed on 100K or $0, or some other amount related to how much tax-deductible interest I claimed over the years?
Thanks,
Joe
Hi Joe,
My read of the situation you outline is that you would pay capital gains on any amount over and above the original purchase price minus any depreciation that you claimed on your taxes in the interim. Thus, the base number would be much closer to $100k than $0.
Best,
Dave
Hi Dave.
Thanks for peaking my interest in this subject, pun unintended.
How about this situation. I have a home that I own with no mortgage. I purchased the house next door with a mortgage and will be renting out my mortgage free home while living in the new mortgaged home. Am I able to deduct the interest cost against the rental income?
Hi Dan,
If you used the mortgage proceeds to purchase the home you will be using as your principal residence then the mortgage interest would not be tax deductible.
It is the use of the funds that matters, not the specific asset that is used as collateral to secure those funds.
Best,
Dave
I have mortage on 2 properties. One Principal house and another rental/investment property.
If I take equity loan from my investment property to pay off my principal house mortage. Would I get tax benefit on the interest I pay for equity loan?
Hi Nidhi,
I do not believe that CRA would allow you to deduct the mortgage-interest uexpense nder the scenario you outline because these funds would be put toward your principal residence, thus making them ineligible.
Best,
Dave
Hi Dave,
Great article! I have a large line of credit available on my principal residence. If I use this LOC to buy a rental condo, would the LOC interest be tax deductible? I will be able to produce proof of rental income.
I believe that you covered this under scenario #1 but just wanted to be sure.
Best regards,
Luke
Hi Luke,
According to my understanding of how the rules work, if you use the LOC on your principal residense to purchase a rental property, then then the interest cost on those funds should be deductibile against the rental income you receive.
Best,
Dave
Hi Dave,
Thanks for your article. I have a mortgage on my principal home. I am planning to rent my principal home and rent another house. So I will be receiving monthly income from my principal home but also paying for my rental place. Is the principal home interest tax deductible even thought I pay rent?
Hi Diana,
Once you turn your principal residence into a rental property, my read of rules would say that you can then deduct the interest cost on the mortgage you have on that property against the rental income you receive thereafter.
Best,
Dave
Thanks Dave. What if I get a mortgage on the mortgage free house and use that to pay off the new principle residence?
Hi Dan,
The test is what you use the funds for. If you use them to purchase a principal residence then the mortgage interest would not be tax deductible.
Best,
Dave
Thanks Dave. Once the funds are used to pay for the principle residence the mortgage is now on the rental property. So for the first year the interest won’t be deductible but after that it would be since it would be used to keep the rental only. Right?
Hi Dan,
That is my understanding.
Best,
Dave
Thanks Dave.
Hi Dave,
I had my principle residences free and clear of all mortgages for a number of years. I then set up a Home Ready Line Account against this property. I took out a mortgage against this account to fund the purchase of a USA rental property for the purpose of generating income. Can I deduct the interest paid? Is there a difference between an investment loan and my Home Ready Line Account? I’m not sure if I used the right method.
Best,
Mario
Hi Dave
A very interesting article. can you tell me what implication occurs if some one purchages a home with a mortgage for principal residence condition and later decide to convert the same one to rental property? Can he or she claim the same mortgage for tax return with CRA
Hi Krishna,
In the scenario you describe, you would be able to deduct the mortgage interest cost during any year that you rented out the property.
Also, my understanding is the when you sell the property, CRA will pro-rate the capital gain payable based on the number of years you used the property as a rental. So, for example, if you owned the house for ten years and rented it out for five, if you made a profit of $100,000 on the sale, then you would owe capital gains tax on half of that amount since you used the property as a rental for half of that time period.
Best,
Dave
We have no mortgage on our home are thinking of buying a condo to rent out. Can we claim the interest if we use a line of credit instead of a mortgage for the purchase
Hi Bill,
If you borrow money to purchase a rental property, the interest cost for that loan can be deducted against the rental income. It doesn’t matter what property you borrow that money against and its doesn’t matter whether that loan is a mortgage or a line-of-credit. The key is that the funds were used to purchase the rental property.
Best,
Dave
Hi Dave
Thank you for your answer.
Hi Dave
My mortgage lender has financed my home as a principal residence and made me to sign with notary that I would use this home as a principal residence during loan maturity period. Now my situation is changed and I need to rent out this home. Can I rent out this home for income generation?What steps I should take with lender to change the status of my property from principal residence to rental. Should I inform the lender about the changes of status of property?
regards
krishna
Hi Krishna,
In my experience, lenders are generally understanding if you have live in the property for a length of time after purchasing. After all, no one can predict their future, especially several years down the line. I think your lender would be okay with your renting out the property as long as you disclosed that you were using it as such at renewal, but if you’re not sure, I would just call them and ask.
Best,
Dave
Thanks Dave for your suggestion
Hi Dave, further to Nidhi’s comment above, if you have a HELOC on the rental property, and choose to take equity out of that and put it against your primary (say 50K a year for 4 years (no tax deductions)), when and if you choose to convert the HELOC back to a conventional mortgage (after applying the equity to your primary residence mortgage), does the interest on that “new” conventional mortgage on the rental property become tax deductible? It is by default in regular circumstances, but I’m curious about the scenario outlined above, where the value of the mortgage accrued by taking equity out and applying it to the primary residence. Thanks.
Hi Kevin,
It is the use of the funds, not the product type (HELOC/mortgage) that determines whether the interest is tax deductible.
As such, if you refinance a rental property and use those funds to pay down the mortgage on your principal residence, the mortgage interest is not tax deductible, regardless of the loan product you use to borrow those funds.
Best,
Dave
Hi Dave, I paid off the mortgages on two rental properties and now need to raise cash. If I get a mortgage on one of the rental properties will the interest be tax deductible?
Hi Keith,
That depends. The key test is what you are using the funds for, not where you are sourcing them from.
Best,
Dave
Dave
My wife and I purchased a home from our in law due to some financial issues. He resides in it now. We used our HELOC to put 10% down on the purchase of the home. We were able to put 10% only down on a second property because it is for an inlaw. In reading your responses to similar inquiries, is the interest on the 10% tax deductible? IE: $30,000 used from the HELOC to buy the home.
How do I separate the 10% interest we used to buy the house from the the entire interest payments owing on our current property? No mortgage here.
Would starting a company be beneficial for me and putting this new found residence under a company?
Thanks
Bill
Hi Bill,
Rental properties require a minimum down payment of 20% so if you were allowed to put down only 10%, I think that is because the property is being treated as a second home and not as a rental property (because your renter is a family member and not an arms-length person). If that is the case, then the mortgage interest would not be tax deductible.
You should check with your accountant by that is my understanding.
Best regards,
Dave
Hi dave,I was wondering if I took my rrsp,s and my tfsa , purchased a rental property, which would be mortgage free, then take rental income and put all of it into investments ,would it be tax wise or to complicated. Thanks have a great day
Hi Dale,
In the scenario you describe there would be no mortgage interest to make tax deductible (because the house would be free and clear).
Best,
Dave
If I don’t use the LOC from my principle residence to buy a rental property but rather refinance my principle residence to do equity take out to purchase the rental property and incur transaction cost to do that such as legal etc. my question is as follows:
1) After refinancing my principle mortgage payment increases. Would the incremental Interest cost (Post refinance minus pre refinance) be tax deductible during the period I earn rental Income?
2) Would I also be able to write off my transaction cost (Legal + Interest penalty) that I paid to refinance my principle residence as the intent was to use the funds to buy rental property?
Thanks
Hi Shahid,
If you pull equity out of your principal residence and use those funds to buy a rental property, then the interest expense on those additional funds is tax deductible against rental income you receive for the property. In addition I believe that any costs associated with the transaction can also be deducted (but you should double check with your accountant just to be sure).
Best,
Dave
Hi Dave,
I have a relatively large investment portfolio. I am a few years to retirement and plan on buying a cottage. My house is paid off with no mortgage. What I plan to do is sell enough dividend paying investments in my margin account to buy the cottage, then set up a Heloc to repurchase my dividend stocks. I plan on using the cash flow from my investments to cover the interest payments. Would I have any issues deducting the interest payments on my Heloc?
Thanks for your help.
TJ
Hi TJ,
As long as you use the borrowed funds to purchase eligible investments (see my post for details on that) then you should be fine. That said, if you want to be 100% certain, I advise that you speak with your accountant or call CRA.
Best regards,
Dave
I wonder if I use a LOC secured by my current home(which also has a rental suite) to purchase a second home THEN move into that second home and rent my previous home and suite can I deduct the interest payable on the LOC. I would of course declare the rental income earned on my former principal residence.
Hi Jake,
It is the use of the funds that determines whether they are eligible for the tax deductibility.
In the example you cite, you would be using the funds to purchase a property that you would then live in as your pricipal residence, and as such, your interest paid on that money would not be eligible for a tax deduction.
Best,
Dave
Hi Dave,
Great article and clarifications. You have emphasized that to be tax deductible the use of the money must be for an investment not your principal mortgage. What if you borrowed money and used it to pay the expenses on your investment property (condo fees, mortgage interest, property taxes, etc.). Then your own money that you would have otherwise used to pay those expenses is used to pay down your principal residence mortgage. Would that qualify as a tax deductible loan use?
Mike
Hi Mike,
Based on my understanding, if the borrowed money to cover expenses on your rental property then the interest expense for those funds should be tax deductible.
Best,
Dave
Hi Dave,
Thanks for the great article. So I’ve had a rental property for 8 months now. All this time, I’ve been using the rental cheques to cover the expenses such as mortgage payment, condominium fees, property tax, rental insurance, water heater rental. Since all these expenses have already been paid, can I go back now and withdraw all those expense amounts from my HELOC? My reason for this is to free up thousands of dollars to transfer into my principle mortgage. Since it’s November 2017, I figure I can since I’m still in the current tax year.
Colin
Hi Colin,
If you borrow against the HELOC on your rental in order to pay down the mortgage on your principal residence then the interest charged on those funds would not be tax deductible.
As a reminder, it is the use of the borrowed funds that determines whether they are tax deductible, not which asset they are borrowed against.
Best,
Dave
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
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
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
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
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
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
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
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
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
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
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?
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
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?
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
Hi Dave,
If I use the HELOC ~ 110K from my investment property as downpayment for a second investment property (preconstruction) would the interest on $110K be tax deductible?
Regards,
Anna
Hi Anna,
Under the scenario you describe the interest should be tax-deductible, but if there is no income associated with the property (because it is not built yet) there wouldn’t be anything to write it off against, at least initially.
Given that, I suggest that you check with your accountant to confirm whether the interest expense can be deferred to future years.
Best,
Dave
Hi Dave,
I have a mortgage on my Principal Residence of 320K and just refinanced it to 520K. So i got 200k paid out to myself because I wanted to invest this 200k in a savings account earning interest or in the stock market. As long as I invest this money, can I deduct the interest on this 200k?
I read the other comments and this was already asked but for a situation where it was on a rental property. This is my principal residence so is this still allowed?
Thank you!
Hi Mitchell,
The fact that you borrowed the money against your principal residence is not an issue. It’s the use of the funds that matters.
My understanding is that the funds must be invested in something that either pays a dividend or has the realistic prospect of paying a dividend. Under that definition, interest from a savings account would not be eligible.
That said, I advise you either call CRA or check with an accountant to be sure.
Best,
Dave