Chances Are You Don’t Have All The Money You Need To Buy All The Real Estate You Want

Making Your Mortgage Interest Tax Deductible

By Calum Ross

A mortgage is often the largest debt people incur. The stress associated with its size often sets people on a mission of trying to pay it off as quickly as possible. This goal is often the previous generation’s well-intended advice that actually lacks financial wisdom and often has negative results.

Advice is one thing that is freely given away, but watch that you take only what is worth having. The publication by Fraser Smith, “The Smith Maneuver,” provides instructions and quantitative proof showing the benefit of rethinking paying down the mortgage. It challenges us to re-consider debt’s place in a financial plan.

The concept is quite simple; borrowing to invest in non-registered assets, unlike borrowing for a family home, allows interest to be tax deductible (according to CRA – providing there is an expectation of profit). According to Canada Revenue Agency, rules governing interest deductibility for investing are set out in IT-533 Interest Deductibility and Related Issues – October 31, 2003, and represent the most current reference at the time of writing.

The change in reason for borrowing lowers after-tax borrowing costs, as the interest creates a refund at your marginal tax rate. At a 40% tax rate, interest cost is 40% less. To put this in perspective, a 5% mortgage becomes 3% after interest deduction. As an investor, if the after tax rate of return exceeds 3%, you are getting rich with someone else’s money.

Each mortgage payment is a blended portion of principal and interest – interest incurred to borrow for the home (not tax deductible), and principal that is paying off the total mortgage balance outstanding. At the start, a mortgage payment goes mostly to interest and less to principal – this reverses over time. As the mortgage is paid down, the home equity can be re-borrowed to invest. Using the equity to invest, the interest on this borrowing is tax deductible and unlike unused home equity, able to grow and compound.

The homeowner who puts $100,000 of equity into an income producing asset with an ‘expectation’ of profit can write off the associated interest cost. At a 40% tax rate, the investor’s real cost to borrow is actually 60% of the face rate of interest as a result. At the 3% prime rate of today, the real cost to borrow is 1.8% (60% of 3%). In other words, to realize a gain, the after tax return need only be above 1.8%, which is actually pretty easy to do with a competent advisor. While interest rates vary, the long run probability for gain is clearly strong, with numerous investments and specifically with real estate. As the strategy points out, since the house is the security, the investment portfolio is free and clear and provides liquidity if ever required along the way.

Using home equity responsibly is a powerful tool for asset accumulation. While you may always have a mortgage – a six figure mortgage with a seven figure investment account gives little concern. For advice on this strategy see www.smithman.net. While what you owe is important, what you are worth after tax is what ultimately fulfills most financial goals. Remember that this is not a strategy to use without advice, but great advisors in Canada should easy to find in any market.

Calum Ross was ranked as the top producing mortgage broker in the country by Canadian Mortgage Professional Magazine. He is regularly featured in the media as a mortgage expert including appearances on Canada AM, CTV, City TV and Inside Toronto Real Estate. He is the mortgage columnist for New Homes and Condos magazine and The Condo Guide and is regularly quoted in newspapers such as The National Post, The Globe and Mail and the Toronto Star. He holds both a B.Comm and MBA in finance and recently completed the Comprehensive Leadership Program at Harvard Business School.