MORTGAGE INTEREST AS A TAX DEDUCTION IN CANADA

 

 

NOTE: January 6, 2010 update - Watch David Ingram talk about how to make your Canadian Mortgage tax deductible on Around the World

 

 

People in Canada usually think that Americans have it all because they can deduct their mortgage interest and property taxes on their income tax return.  It's true, these are legitimate deductions in the US, but...  

to do so, most families give up (in 2010) a $11,400 standard deduction.  This is fine if your mortgage interest is over $9,000(and property taxes add up to take the total over $11,400) but the practical fact is that "Average Joe" in the US pays about $1,295/month PIT (principle, interest, taxes) which puts him right on the cusp of whether the deduction is a gain or loss. 

 

In addition, Americans might have to PAY TAX ON THE PROFIT when they sell their principal residence.  If you have lived in the house for two of the last five years, there is a $250,000 per person exemption. 

The US deductions are not free. There is a future potential tax liability.  The principal residence house profit can be taxable even if you did not claim the deductions.

 

Canadians DO NOT PAY TAX on profits from the sale of the family home.  AND, Canadians can re-arrange their affairs to make their mortgage deductible.

 

HOW TO MAKE YOUR CANADIAN MORTGAGE INTEREST DEDUCTIBLE FROM YOUR TAXABLE INCOME 

(and maybe make a million on the side at the same time)

It is useless if not downright dangerous to plan personal finances around "US", so let's get on with planning for "ME". We will either be divorced or a widow(er) or dead.

We all have to plan for ourselves alone and assume the other person will be gone. Let's also make our decisions based upon investments that we understand as opposed to diamonds, or jewelry, or art or antiques, or strip bonds, or or or....

 

We all know that indulging in consumer credit at high interest rates to purchase diminishing assets is a luxury we cannot afford. Compound this fact with the non-deductibility of that high interest and we come up with...

rule number 1: INTEREST PAYMENTS THAT ARE NOT DEDUCTIBLE ARE A NO NO!

However, before I talk about how to make interest payments deductible, I want to point out that nothing can be deductible if you do not have a record of it.

This whole subject makes me angry. If I start sounding like the movie "NETWORK", do not be surprised. People tell me, "lawyers cost too much" and then pay through the nose, because they did not consult a lawyer in time. They tell me that doctors cost too much and then find out just how much they do cost when they do not pay their medical premiums. People tell me that dentists cost too much and do not brush their teeth. But what really makes me angry is when they say that accountants cost too much and wander into my office or anyone else's office with a shoe box or garbage bag or attache case full of receipts with three different years on them. Why don't they do a basic sort... at least into years? It is this same person who will complain when we charge for sorting the receipts. All we have to sell is our time; if you use an accountant's time, expect to pay for it.

 

Would you like to know the simplest way to look after your records if you are a commission sales person, farmer, fisherman, or just plain one man or woman business? It isn't tying you to a computer program. TRY THIS!

KEEPING RECEIPTS THE EASY WAY

Take over one drawer in a desk or vanity and get about 25 or 30 # 10 envelopes. Label them with an expense item in your business or work: Gas, Oil, Hotels and Motels, parking, telephone, and so on. When you get home at night or to the office in the morning, merely empty your pocket, purse, etc. into the relevant envelope. Around Jan 15th of the next year, simply add up the contents of each envelope and write the amount on the outside of the envelope. Those are your expense items for your profit or loss statement or expense statement in either Canada or the United States.

 

YOU DO NOT NEED DOUBLE ENTRY BOOKKEEPING FOR YOUR "SIMPLE" BUSINESS. The only reason for double entry bookkeeping is to try and stop people from stealing from you. If you have no employees, no one is stealing from you.

If you are audited by the Internal Revenue Service (IRS) or the Canada Revenue Agency (CRA), you have all the relevant receipts for their query neat and totaled. Best of all, when you go to your accountant or tax man to have your return prepared, you will not be paying $75 to $150 an hour to have someone else sort and add your receipts. When it comes to an audit, the auditor will prefer to have the receipts segregated in this manner.

On the subject of why you should keep receipts, try this one on for size. We will pretend you earn $95,000 per year and are on the edge of a 40% marginal tax bracket. You take a business trip from Vancouver to Victoria. It costs $150 for the ferry there and back. You spend $15 for a meal on the ferry going and $30 for a meal there and $30 for a meal coming back (you meet a client on the ferry and buy him dinner); total expenses $225. If you do not keep these deductible receipts, you might just as well have torn up a hundred dollar bill and thrown the pieces overboard.

At least most of that trip was deductible. Even though you spent $225, you got $125 back in the form of a tax refund or tax you did not have to pay. It only cost you $100. However, one of the rubs in this life is that if you just decided to take your family out to dinner and spent $70, you would have to earn $120 and pay $50 tax to have $70  to pay for the dinner.

This is the best example to arrange your affairs to make them 'deductible'. WORK AT IT! If you do not, no one else will and you will pay three to four times as much for the same thing.

By the way, the VISA / MC / AMEX receipt is NOT sufficient.  The reason is that people going to lunch have been known to give the actual receipt to one person while the other person uses his or her VISA slip as a receipt.  Both the CCRA and IRS insist on the actual receipt.

 

PAYING FOR A NEW CAR

Try this. I will ignore any finance charges for the purpose of this example and assume everyone has the ability to pay cash, (the example is far worse with interest factored into the equation).

A commission salesman buys a $24,000 Magic Wagon and it is used 75% of the time for business. He is able to write off $18,000 of the purchase price of the car and gets back at least $8,100 as a tax refund. The car cost $16,000 or so in out of pocket cash. Or the salesman would have to earn $30,000 and pay $14,000 tax to have $16,000 net to pay for the car. His neighbor buys an identical car and has to earn about $44,000 and pay $20,000 tax to have $24,000 left to pay for the car. Add in the differences in gas, oil, insurance and interest and the cost can easily be two or even three times more to pay for the non-deductible car.

NOT KEEPING RECEIPTS IS EXPENSIVE!

If you can't afford a new car and your salesman neighbor buys a new car every year, it is partly because the tax system is helping to pay for it.

Although there is no doubt that a self-employed person is entitled to certain expenses, as is a real estate agent or even a sea captain, YOU MUST HAVE RECEIPTS.

In 79 DTC 899, Judge Delmar Taylor made the ruling that although employees earning commissions were permitted deductions for certain expenses not deductible by other types of employees, it was incumbent upon them to maintain records and documentation in support of such expenses.

When no documentary evidence was produced, the whole claim was dismissed. It should be noted that Mr P Litvinchuk had earned $47,700 in 1974 and claimed unvouchered expenses for "parking meters, drinks, pay phones, etc. of $2,400". He earned $55,570 and claimed $2,000 for 1975, and during 76, he earned $67,834 and claimed $600. The tax office offered $600 for 74, $600 for 75 and $300 for 76 and Mr Litvinchuk appealed to get his original claim. Judge Taylor gave him nothing.

 

Many taxpayers seem to think that there is a reasonable or an `allowable' amount of 5%, 10%, 15%, etc. that the tax office allows without receipts.

NOT SO! Although the policy of the tax office is to allow `something', they in fact do not have to allow anything as the previous case showed. (For more wonderful `real life' stories of tax cases, see my "The Ultimate  Year Round Tax Book" which is out of print and now online - was published by Hancock House). Certainly the amounts claimed by Mr Litvinchuk were small in relation to the earnings, but as you have seen, reasonableness does not enter into it.

Tax Law is like Parking Meters

Either you are over-parked or you are not. The fact that you were going for change for a $1,000 bill is irrelevant. You should have had a Magic Wagon with a built in change dispenser. The difference between over parking or speeding and income tax is that when they catch you for speeding, they do not go back three years and give you a ticket for every day you sped in the last three years. Income tax goes back three, four, up to eight years on a regular basis.

And, when you get caught for speeding, you KNOW you were breaking the law.  You would never tell the nice traffic officer, "what do you mean, I can't speed here? I have been speeding here EVERY DAY FOR TEN YEARS!"  But, when the CCRA auditor suggests that you can't claim something, the first thing you will say is:  "I've been claiming that for ten years and EVERYONE ELSE at the office has been claiming it as well."

On the other hand, also in 1979, a Sea Captain, Paul Allen from Lunenburg, Nova Scotia, who was an employee, was allowed 100% of his truck expenses because it was used to transport goods to and from the boat and was used exclusively for boat related activities. He also used his car for business trips and was allowed 20% of his car. He had an office in his home which he used to interview prospective crew members and was allowed 10% of the expenses of his house and last but not least, he had spent $447 for a party at his house (he did not have receipts) and Judge J B Goetz allowed the total amount because the party was for crew members, suppliers and maintenance personnel.

 

Obviously, the quality of the evidence, the mood of the judge, and the circumstances change in each and every case.

 

I will now return to the subject of making interest deductible.

Many years ago I was very heavily into rearranging peoples' finances to make mortgage interest deductible. The 1979 election of Joe Clark and the actual production of a mortgage interest deduction form with the tax return stopped the momentum. Lately, it has been rare for people to come in and pay their money to make their interest deductible. And this is strange, because of course the interest is usually three times what it was in 1977 and 1978. In fact, in 1978, I would get thirty people a month and now I get 20 a year. I guess that people just like paying taxes or maybe those that would have come in and paid a $300 fee have now figured it out themselves by reading my book or a prior edition of this newsletter. Or, maybe they just want to pay more tax.

Our "deductible mortgage" program typically took four to five years to implement. Joe Clark's government was bringing the deduction in for mortgages up to $50,000 over a four-year period. The deduction was actually included on the 1979 Income Tax Form. But Joe Clark was defeated and so was the deduction.

 

The biggest part of making your mortgage interest tax deductible involves purchasing some rental real estate or having some other business proprietorship - you need an outside (of your paycheque) source of income.

I am proud to say that back when we were doing this for a lot of people, as well as making the house mortgage deductible, in most cases the rental real estate went up significantly. Some of our purchasers in Brampton realized $120,000 profits from $10,000 down and made their mortgage deductible at the same time.

 

CANADA VERSUS THE UNITED STATES

The mortgage interest situation in Canada is different from the US. In Canada, mortgage interest is not deductible where the mortgage was put on the house to buy it as a principal residence or as a seasonal cabin/chalet. On the other hand, we in Canada do not have to pay tax on the capital gains profit when we sell our house. In the United States, there is a standard deduction or a person may `itemize' deductions. Itemized deductions include mortgage interest, property taxes, medical and dental, and even income tax preparation fees. When a mortgage is getting small (because of age or buy down), it is possible that a family of six could have a larger standard deduction than the mortgage interest and property taxes works out to and they have to pay tax on the profit (capital gain) as well.

And in the States, mortgage interest is no longer deductible on that part of a mortgage, which exceeds the original purchase price. So after years of saying that there has been less need of my type of service in the US, it has become obvious that the US is changing to a 'more Canadian' type of system makes the following proposal appropriate for both countries.

 

It used to be that all other interest in the US was also deductible. Your Sears interest was deductible, your Visa interest was deductible, and your mother's car loan was deductible. But all that has changed. With the rules 'Canadianized' over a four-year period starting in 1986, US taxpayers can no longer claim all that interest. As a consequence, US taxpayers have to start rearranging their affairs in the same manner.

HOWEVER, ANYONE WHO WANTS TO REARRANGE HIS OR HER AFFAIRS, CAN MAKE HIS MORTGAGE INTEREST AND CAR LOAN INTEREST, AND BOAT LOAN INTEREST DEDUCTIBLE. 

It helps if you are self-employed. But if you are not self-employed, the same results can be had with the ownership of rental property or a good mutual fund portfolio. It is also possible to make a million on the side while you are rearranging your affairs.

KILL YOUR CORPORATION

Oh, I almost forgot. If you are the proud owner of a one-person corporation, this will not work. In fact if you are the proud owner of a corporation, with the exception of a couple of very esoteric credits like Scientific Research and Experimental Development (SRED) or Flow Through Shares, you will pay MORE income tax with a corporation than without. In addition, you will pay an easy $600 to $1,000 more for tax and legal work per year.

If you have a corporation, you should likely kill it, or at least put it on a back burner for a while until you get all your interest deductible. If you have a corporation for 'insurance purposes', i.e. so that you can't be sued, forget it. The courts find it very easy to go after the major shareholder of a corporation where that shareholder is the only or chief employee and where the problem arose because of the actions of that employee/shareholder.

Example Situation
A dentist making $100,000 a year wants to buy a $100,000 sailboat but he has no cash. He could afford the $1,000 a month payment if he did 100% financing but he would have to make $2,000 a month and pay $1,000 tax to have $1,000 left over for the boat payment if the interest was not deductible. If the interest were deductible, he would pay the $1,000 a month interest and get a $500  per month cash deduction off his income tax.

We will assume he has a $200,000 house with a $50,000 mortgage (Lives in Lunenburg or Prince Rupert, etc.). We will assume that his practice grosses $20,000 a month and that after all expenses, he has exactly $100,000 left as his earnings.

As we have already discussed, if he puts a mortgage on the house to buy the boat, the interest is not deductible because the money was used to buy a boat and yacht interest is specifically forbidden as a deduction in Canada unless the boat is a full time working boat (could be a rental). In the US, if the original cost of the house was $100,000 and a new mortgage was put on up to $150,000 from the $50,000 that was outstanding, only interest on $50,000 would be deductible. If the original cost was $150,000 or over, than the interest on the whole $100,000 WOULD be deductible.

But let's take the worst case scenario and assume the original cost of the house was $50,000 and the $50,000 loan on it now was used to put the kids through university and fix the roof and plumbing. Therefore, any increased loans against the house bears non-deductible interest.

The dentist has $140,000 worth of expenses per year.  The expenses are for rent, light, heat, telephone, labs, supplies, repairs to equipment, assistant's wages and dental technicians. If he were short money some week because a cheque from a dental plan was late, and he borrowed money to pay for the rent and his assistant's salary, the interest would be deductible.

So what SHOULD the dentist do?

First our dentist goes to his or her `creative' mortgage person or bank manager (Joan Marsh maybe at (604) 535-9981) and says, "I want to arrange a floating business loan for my practice as a dentist. The total amount of the loan may be as much as $100,000." The bank manager will usually say yes, because our dentist is going to give the bank a  mortgage on the $150,000 equity in his house.

Each month for the next year, our dentist deposits all the gross receipts of the practice into a term deposit. He takes out his own personal expenses only. EVERY SINGLE TIME HE NEEDS TO PAY A BILL FOR THE PRACTICE,  HE BORROWS THE MONEY FROM THE BANK THROUGH HIS PRE-ARRANGED FLOATING BUSINESS LOAN. When the Term Deposit is up to $100,000 (or $114,000 including GST and PST), he takes the $114,000 out and pays cash for the boat. The net result is that there is deductible $114,000 loan against the business and every single cent can be shown to have been borrowed to pay business expenses. If our dentist or doctor or lawyer or accountant has any other non-deductible interest (such as the first $50,000 on the house), he can now use the boat as security to borrow more money for the business while he pays down the other non-deductible loan.

 

 

HOW ABOUT A SHOE STORE?

 

A Shoe Store Owner - Making His Mortgage Tax Deductible
The (proprietor) owner of the store wants to buy a nice little one bedroom Condo in Winnipeg for $60,000. He has no money saved and the shoe store is just making it plus a little extra but he is already paying out non-deductible apartment rent of $650 a month. If he could pay $800 a month deductible interest instead of $650 a month non-deductible rent, he would be about $200 to $300 ahead each month because of the tax refund/deduction.

What does he do? What DOES he do??

Simple....  He stops paying his bills for a couple of months.  Every cent coming in goes into a term deposit.... Every cent except for what he needs for personal expenses. When his creditors have yelled a couple of times he goes to the bank and borrows money to pay them. What does he use as security? He uses his term deposit of course. Depending upon the monthly gross of the business it will take six months to a year to get the $60,000 into the term deposit. Now he has cash to pay for the apartment. Of course the bank won't release it because it is security for their business loan.

What does he/she do? He slyly suggests to the bank manager (get in touch with my friend Joan Marsh if you can't find a friendly bank manager) that he will have a paid for condo and the bank could take the condo as secondary security as well as a charge against all the business assets.  The net result, a $60,000 loan with the main security being a condo, BUT the money was not borrowed to buy the condo. Every cent was borrowed to pay rent on the business, pay staff, buy stock, advertise, etc. It is an absolute paper trail of source and application of funds. (For an example of about thirty tax cases on deducting interest, see my THE ULTIMATE TAX BOOK, published originally by Hancock House Publishers Ltd and now online here. 

 

So I repeat, anyone who is self-employed or owns a small business (proprietorship, not corporation), or WHO OWNS RENTAL PROPERTY or an income bearing portfolio, can make his or her mortgage deductible. It might not work in two years, it might take three, four, five, or even six years, but IT WILL and DOES WORK.

 

This is how you do it. Let's assume you have rental property (If you don't, we'll talk to my friend Ozzie Jurock and get you some rental property in one of the small towns around BC, or maybe a ski chalet.)

When you have a business, are self-employed or have rent coming in, no one tells you in what order you have to spend your income.

For instance, if not in this program and you had to borrow $1,000 to fix the roof on your rental property, WE KNOW `automatically' that the interest on the $1,000 loan is deductible. Where we have a problem in our mind is when we have the money available to fix the roof and I say "BORROW IT ANYWAY".

 

The problem is that we have been conditioned by some antiquated accountant to keep our business and personal accounts separate or set up a separate account for our rental house. Then we are told to pay those bills out of that account. 
THAT IS THE WORST ADVICE YOU EVER RECEIVED ABOUT FINANCE (well maybe second to the advice to buy a whole life insurance policy). 

When you have a separate account and you have used all the money from the rent to pay the bills for the rental house, and you still need money to fix the roof on your own house and you borrow the money to fix your own roof, the interest is not deductible.

But...

if you took the rent money received and paid cash for the roof,

then borrowed the money to make the mortgage payment for the rental property,

the interest would be deductible. 

The money from the rent (or from the dental fees, from the accounting fees, from the shoe sales)
is YOURS FIRST to do with as you please. YOU, and ONLY YOU! decide what you are going to pay first. 

Unfortunately, we have been conditioned to pay "DEDUCTIBLE" bills first when we should be paying "NON DEDUCTIBLE" bills first.

 

 

Look at the "flow through" for the first year of a typical MURB of which there were some 350,000 sold to investors so that they could CLAIM A RENTAL LOSS on their income tax return. Remember, a MURB is just a multiple unit residential building.  MURB's still exist.  They just do not have as much artificial tax deduction associated with them.

A typical situation might be that you take in $11,000 rent and spend $17,000 and you are encouraged to do this by the Governments of both Canada and United States because it is cheaper for the governments to give you, the investor, a tax deduction then it is to provide subsidized housing. In this example, where are you going to get the $6,000 shortfall? You have to earn it or borrow it. If you borrow it, the interest is a deduction. Why not take the $11,000 rent and pay down your own mortgage by $11,000 and borrow the whole $17,000 to fund the rental property.

 

Let's take another tack at it. (A little nautical term there).

Let's say you want to open up a camera store or a shoe store or a store to sell western hats. You finally heard about urban cowboys and realized Stetsons are big business. Of course, they stopped selling three weeks ago, but you just found out about them so you are going to open up a store and sell western hats. You borrow $30,000 and purchase $30,000 worth of hats from the Stetson Company. In the next year, you pay out $6,000 interest, $12,000 rent, $15,000 for wages, $5,000 for other miscellaneous things and $2,000 for heat and light. You've spent a total of $70,000 with the expectation of selling some hats. At the end of the year you haven't sold one. Where did you get the $70,000 in the first place? You put a mortgage on your house. The money was borrowed for business purposes, voila, the interest is deductible, even though the loan is a mortgage registered against the house.

George Hatton, CA, a Cartier Partner who worked out of the CEN-TA location at Park Royal in West Vancouver read the above and wanted a caution put in here.  He is right.  

George wrote, "The concept works as well for a portfolio of Mutual Funds as it does for Real Estate.  The difference is that the fund value changes daily and you (and the lender) know what that value is."  Real Estate Values also change daily but you don't really know an exact value and it is a time consuming and expensive process to redeem real estate.  On the other hand, if you have made an inappropriate stock loan, it is common for the Stockbroker or lender to call the loan when 'the lender' gets nervous, selling you out of your position, and leaving you in the position that you can't "catch up". This is exemplified in the next case.

 

STOCK SOLD (shares, not stock in trade)

In 1985, Russell I Emerson lost his claim.  He had purchased $100,000 of stock in 1980, with borrowed money. When the investment turned out to be bad, he sold the shares in 1981 and incurred a $35,000 loss.  He claimed this loss in 1981 and deducted $17,500 as an allowable business investment loss. He also refinanced a $63,750 loan to pay off part of his previous loan.  (Please note that the amount of the loan exceeds the loss and confuses the issue.) The tax office disallowed the interest expense on the grounds that the investment no longer existed (shares had been sold). Judge Cullen of the Federal Court -- Trial Division agreed with DNR. (In 1993, Canada's tax law changed to allow interest on business expenses when the business has been closed).

 

Jumping back a couple of paragraphs, you will see that it is easier to think about it in terms of a store than in terms of a rental building.  Remember, a rental house or a rental apartment, or a rental cabin, or a rental sailboat, or a rental motorhome or a rental airplane is a BUSINESS. So, (my English teacher will be rolling over in her grave) if you borrowed the whole $70,000, the interest would be a tax deduction.

 

Let's look at the hat store in another light. You sold $20,000 worth of hats. If you used this against your $30,000 inventory, you would still have to borrow $10,000 and the interest would be a deduction.

Besides covering business expenses you have had to live. You have needed more money for your personal living expenses. You have to eat and you have purchased a lot of booze to drown your sorrows since you are not selling many hats. The question: Where did you get the $10,000 for personal living?

Well, if you borrow $10,000 for food, light and heat for your house, the interest is not deductible. NO - not one cent. So what should you do? What SHOULD you do? If selling hats has generated any income, you should be using that income to pay for your personal expenses, then borrow the money to cover the business expenses ( sound familiar, do you see the difference?). If you borrow money for personal needs such as food (both countries now), you have to use after tax dollars to pay the interest because the interest is not deductible. But if you borrow money for business purposes the interest is a deduction. Therefore, always charge your business expenses and use the money (cash flow) from your business to pay your personal bills. Anyone who is self-employed or who owns rental property should be following this plan.

Watch: At $40,000 a year if you pay out a $1,000 interest bill, which is not deductible, you have to earn $1,600 and pay $600  tax to have $1,000 to pay the interest.

But!: If the same $1,000 interest is deductible, you will get a $400 refund for a net cost of $600.

Non-deductible interest costs twice as much in earnings requirements as deductible interest at the lowest rates. At higher marginal tax rates, it can cost up to four times as much.

 

MEANWHILE, BACK AT THE RENTAL APARTMENT

You just assumed that the first $11,000 should be used to pay the interest, the taxes and the repairs and maintenance on the rental unit. Does it have to? It's your money isn't it? You can do whatever you want to do with that money. You could take it and drive to Mexico City, you could buy a used Cadillac, Or you could use it to put your kids through school.

You can do whatever you please with that money. What usually happens is that, because of your desire to keep detailed records, you set up a separate bank account for the rental property. The money goes into this account and you are probably putting in money from your salary to subsidize the payments. At the same time you borrow money to buy a TV set or a car or to take a vacation. You borrow the wrong money don't you?

What you should be doing, of course, is using all of the money from your salary plus the $11,000 rental income to pay down your mortgage on your own principal residence. Remember, the money you earn from any and all sources is yours first. You make the decisions about what to do with it.

Now you want to make your mortgage payments deductible. If you have a creative bank manager, and he or she can do a little mathematics (find one who can) and if you have an outside source of income, THIS is what you do...

Assume that you have a $49,000 mortgage for this example.

Assume your regular payments on the mortgage are $8,000 per year. If your outside source of income provides you with $11,000 which you apply to the non-deductible mortgage this year, you would reduce your non-deductible interest costs and you would reduce the principal of the mortgage. So, in the first year of this example use $11,000 you have grossed from this outside source (business or rental property) to make an additional payment on your personal mortgage.

You must still pay the operating expenses for your small business or pay the mortgage and operating expenses for your rental properties. Where do these funds come from? You borrow them of course (perhaps using the new equity on your personal house as security), and now the interest is clearly deductible on that loan.

Now, what has changed at the end of the first year? How much money do you owe at the end of the year? You owe $38,000 on your personal mortgage because the additional payment of $11,000 has reduced the principal portion of your mortgage. Because you borrowed the money to keep your small business operating or borrowed to keep the mortgage payments, taxes, insurance and repairs current on your rental property, you have another loan of approximately $11,000. You still owe $49,000. But the difference is that the INTEREST ON THE $11,000 is DEDUCTIBLE.

(You may have noticed that I have taken no principal off the loan when we are paying $8,000 against a $49,000 balance. The reason is that this was originally written at the height of the interest rates when 15, 17, 19, and even 22% mortgages were floating around. 16% interest on a $49,000 mortgage leaves no significant principal reduction. Many people have still have 14 or 16% non-deductible second mortgages. The principle is very valid. It works even better if you have an older mortgage and are making significant principal reductions with your basic monthly payments.)

 

Today, many people have 14, 18 and 26% Visa Card or Second Mortgage interest rates.  I know that when I wrote this, Nov 8, 2001, I could get a mortgage in the 4 or 5% range and that most Vancouver mortgages were going to be $225,000 on a $350,000 or $600,000 house but this is a concept that can be used in Australia, New Zealand, Germany, Cornerbrook, Newfoundland, Coos Bay, Oregon, Chilliwack, Hope, Squamish and Port Alberni. My readers are in 120+ countries and lots of small towns and this is written for "everybody".

 

11% interest on $11,000 is $1,210.  If you are in a 40% marginal tax bracket, you have changed your tax bill by 40% of $1,210 or $484 for this year and next year and next year and next year and next year and next year if that is all you do.

However, if you do it again the next year, you can reduce your tax by another $500 and another $500 until the $49,000 non-deductible is a $49,000 deductible mortgage. 11% of 49,000 is $5,390. 40% of $5,390 is $2,156 less tax to pay.

If we were starting with a $150,000 mortgage at 11%, the interest is $16,500 and 40% tax is $6,600. But it isn't just that simple. If you are trying to pay $16,500 non-deductible interest at 40% tax bracket, you have to earn $27,500 and pay 40% tax of 11,000 (.40 x 27,500) to have $16,500 left to pay the mortgage. In terms of `earning' dollars, your mortgage is costing you 18.3333333%. Whereas, if it is deductible, it is only costing you 6.6% in `earnings'.

If you are renting out property, take all the rent payments and apply them to your personal mortgage. At $1,000 per month rent, it would take about three years to pay off that $49,000 mortgage (assuming you are also making your regular payments).

Every month you are turning non-deductible payments into deductible payments. This is one of the best reasons I know of for buying rental property. 

American readers might wonder what all the fuss is about. They should realize that the majority of `itemized deductions' is composed of mortgage interest and that when you claim itemized deductions, you lose the `standard' deduction. Wouldn't it be nice if you could get the `standard' deduction PLUS the mortgage interest as a deduction. Using the above technique, you can. And if you do, you will get out of the syndrome of deducting state tax one year and paying tax on the refund the next year because it was included in the itemized deductions.)

 

If you have a rental house on which you are losing money, the cash loss (and in the US, depreciation, and in Canada, Capital Cost Allowance on a MURB) can be used as a deduction against other income. Therefore, if you are in a 40% tax rate (federal tax plus provincial and/or state tax plus city/county tax), and are `losing' $400 a month, you would get a $160 / month tax refund or a reduction in the tax you have to pay at the end of the year. Please note that we have added property taxes, repairs and maintenance, advertising, management and depreciation to the equation now.

What do you do the second year? You take income from the rental properties and the normal mortgage payments and you apply both to your personal mortgage. At the end of the year you have paid (your usual $8,000 plus another $11,000) $19,000 against your personal mortgage. At the end of this second year, how much do you owe? $27,000 on the original mortgage plus $22,000 of secondary financing. Keep in mind that your regular payments are not reducing the principal materially. We are going for the tax refund. If you turn around and use the tax refund to reduce your borrowings, then the balance outstanding will reduce faster.

Follow the same procedure for the third and fourth years and apply the tax refunds and your borrowings have been reduced by $5,000 and your interest is all deductible.

 

By now, you should be able to see how to buy your Florida Condominium, your place in the Gatineau Hills, your place in the Gulf Islands and use the rent to pay the mortgage on your place of residence and the interest you are paying becomes deductible. (There must be an expectation of profit, i.e., you must be able to show a structured cash flow projection where it is reasonable to expect that the type of property you are renting will make a profit in the foreseeable future - for more explanations on this point see my THE ULTIMATE TAX BOOK)

Most people should be able to get rid of the non-deductible interest in 4 to 7 years. Perhaps you should purchase two places, or the house next door and use the rental income to reduce your mortgage. Whether or not the property increases in value, simply by making your present mortgage deductible, you would have enough cash flow to ensure that you wouldn't be losing any real money on rental property.

If you are already paying out $5,000 a year non-deductible interest on your house, think about turning it into a deduction on your tax return. If you could reduce your taxable income from $60,000 to $55,000, what would happen? You would save $2,000 in income tax..... That $2,000 will fund $182 a month loss on a rental condominium.

If your choice is between having a clear title house, living there safely and securely, plus buying either Government Savings bonds and/or and RRSP in Canada or an IRA / KEOGH PLAN in the States OR having a clear title house, putting a mortgage on it and buying a condominium in Florida -- you should buy the condo in Florida. Do you remember why you bought the IRA/RRSP? It was so that you would have enough money at age 60, 65 or 70 to take out and have a Florida, or a Hawaii, or a Nevada vacation. Well, the only way to guarantee you will have enough money for shelter, is to buy it today at today's price.

 

But be careful. The following three cases point out the problems with deducting interest and show that it is important to have a proper paper trail.

MORTGAGE INTEREST NOT DEDUCTIBLE

In 1979, there were two cases, which I thought should have been allowed as well.  In the Holman case  (I was involved as agent), Mr  Holman had borrowed money to build a new house.  He used his old paid-for house as security.  When the new house was finished and he had moved in, he rented out the old house.  He then deducted the interest from the rental income.  We argued that the net result of the loan was that Mr Holman got to keep the rental house, and would incur future capital gains tax and rental income tax.  It was obvious that if Mr Holman had sold the old house, bought the new house for cash, and then bought back the old house with borrowed money, it would have been deductible. However, R.  St-Onge, QC, of the Tax Review Board, ruled that the borrowed money was used to buy a personal residence, and the interest was therefore a personal expense and not deductible.

 

Also, in 1979 Eva M Huber lost a similar case, which went one step further.  In this case, Huber sold the old house, but carried a mortgage on it.  She argued that her own mortgage interest was deductible as it was there to enable her to carry the income-producing mortgage (which I think sounds logical). J B Goetz of the Tax Review Board found her position untenable and disallowed the deduction. 

 

The reason that the previous two cases did not win is that they were judged on the 1979 Federal court loss by the Bronfman estate.

 

In 1987, the Phyllis Barbara Bronfman Trust lost its interest claim after a 14 or 15-year fight involving 1969 and 1970 tax returns.  Proving that might and money and the best lawyers and accountants do not always win, the Supreme Court of Canada ruled against the Trust.    The Trust had many investments and when it came time to pay money out to the beneficiaries, the trust decided to borrow the money instead of cashing in investments, which it was holding.  The trust then tried to deduct the interest (similar to the Cochrane Estate case).  The Tax office turned down the claim.  The Tax Review Board turned it down in 1978; the Federal Court turned it down in 1979.  But the Federal Court of Appeal allowed the claim in 1983.  The Supreme Court had the last word in 1987 when it ruled against the Bronfman Estate.

 

DO NOT USE A HOLDING COMPANY

I strongly advise you not to set up a holding company for your real estate investments. If you do, you can't use any of the deductions personally. It is usually impossible to buy a piece of property with little or nothing as a down payment and rent it out for the first couple of years and make a profit. In fact, in real terms, it usually takes about five to seven years for inflation to work its magic and a profit to come into the rental stream. And if you do make a profit with nothing down the first year, you either `stole' the property, or you have put a lot of time, energy or know how into making the property worth more for rental purposes.... Otherwise the tenant should have bought it for `nothing down'.

If you pay cash, you will have a profit. But if you borrow the money for a down payment, you will lose money. If you borrow money to buy real estate and then put your assets into a holding company, there is no profit to use the loss up against because the holding company does not have a profit. You have to make the money from your salary and loan it to the holding company to keep the company going and you can't use the loss as a deduction on your tax return because it is just a loan to the holding company. You very specifically do not want a holding company.

 

THE BANKER DID IT

For several years I sent many clients to one particular banker to get their `creative' financing in place. The banker was also one of the company's bankers and we would kibitz occasionally, and I would ask him when he was coming in to get some advice. He would just laugh and I would leave it alone. Well when he retired five years later, he had amassed (in 1984) a net worth of $480,000 in real estate by following the methods used by the clients I had sent to him.

I have had dentists, doctors, dress manufacturers, mechanics, short people, tall people, fat people, skinny people, special people, average people, and people I do not even like,  follow these concepts successfully.

The aforementioned banker was a total skeptic at first. "If it's so good, why isn't everyone doing it?" "Prove it to me", etc... All we did was keep on sending legitimate, quality clients to him and when he understood the concept, he went out and did it on his own. He started buying some of the `funny' deals himself. So if you go into a bank and explain what you want to the banker, you are doing that banker a favour.

 

I want you to make sure that when you borrow the funds from the bank to make payments on the rental condominium, or the rental house next door, that you can show that you borrowed the money and that it went to the trust company for the mortgage, or the municipality for the taxes or the insurance company for the insurance. When your tenant gives you a cheque for rent, I want you to show that you paid that money on your personal mortgage principal.

 

OPEN VERSUS CLOSED MORTGAGE

Sometimes people say that they cannot do this because they have a closed mortgage. It works best with open or annual or six month term mortgages.

However, if you have a closed mortgage, you can usually pay off 10% extra on every anniversary date. If you pay regular payments, plus 10% extra each anniversary date, it will likely be paid off in six and a half years anyway. So, ?Never say Never!?

Sometimes people listen to me and assume that I am painting a perfect picture. When they go to their bank, trust co., credit union to pay off their mortgage, they are told there is a three-month penalty. They then stop and assume I am wrong or something because of the three month penalty.

It is always worth a three-month penalty to convert an existing closed mortgage to an open mortgage. "EVEN IF YOU HAVE TO PAY 1/4 PERCENT MORE INTEREST OR EVEN 1 and a 1/2 PERCENT MORE".

IT IS BETTER TO PAY 16% DEDUCTIBLE THAN 11% NOT DEDUCTIBLE FOR MOST PEOPLE.

IF YOUR MORTGAGE IS coming up for renewal in Dec, Jan, Feb or March (I will bet that 33% of outstanding mortgages will come due in the next nine months) then it is worthwhile for you to have another appraisal done and a new mortgage written at another institution where they will give you an open mortgage or at least one with better terms. I repeat, an open mortgage makes the system work better.

Just to remind you. I am talking about making the interest deductible on the house that you already have. Instead of buying an IRA or an RRSP, buy a summer cabin, a ski cabin, a waterfront cabin or a sailboat, then use the cash flow the asset generates to make the interest deductible on your house.

 

LET'S REARRANGE THE OLD FINANCES

First, YOU must realize that all money coming into your pocket is YOURS to use first. YOU decide how you are going to dispose of this money. YOU decide whether the mortgage gets paid first (out of those funds) or whether the kids' teeth are fixed. When you are a self-employed proprietor, you realize this only too well.

The ingredients for making your mortgage deductible are:

1.  An open mortgage

2.  A Creative and/or Understanding Banker

3.  An outside source of income where there are deductible expenses such as a rental house, rental condominium (even Hawaii), your own proprietorship business, or a stock trading or mutual fund account which is not registered.

 

The method is simple. All the money that comes in from this outside source PLUS your regular mortgage payment gets paid off on the personal mortgage. At the same time, you have expenses, which have to be paid. The expenses, which includes mortgage interest, taxes, repairs and maintenance, agent's commissions, and other expenses of the rental units, all normal expenses of operating your own business, and the repurchase of stock if you are trading in stock. You see, we all realize that if we had sold off $100,000 of stock, paid off the mortgage and borrowed the money back to buy the stock, the interest would be deductible; but that is a big step. What we miss is that we can do this "little steps" at a time.

 

MUTUAL FUND PORTFOLIO

For instance, if all you have is a mutual fund account with reinvested dividends, TAKE THE DIVIDENDS INTO YOUR OWN HANDS AND PAY DOWN THE MORTGAGE AND BORROW THE MONEY TO BUY "ABOUT THE SAME" AMOUNT OF MUTUAL FUNDS THAT THE DIVIDENDS WOULD HAVE BOUGHT. This works, even if you borrowed the money to buy the mutual funds in the first place.

PAYING OFF OUR PERSONAL MORTGAGE IS THE FIRST STEP TO FINANCIAL FREEDOM.

If our `non-creative accountant' told us we should incorporate, before we had the mortgage and any other personal debt paid off, we have to put the corporation aside for a few months, until enough cash flow has been generated to pay off the mortgage.

 

Here Is How This Works For The Third Time.

You have an open mortgage (or credit card debts) at 15% for $50,000.

In order to pay the $7,500 interest, you or someone in your family must earn $14,000, pay tax of about $6,500 to have the $7,500 left over for the non-deductible interest payment.

If you have a business grossing (remember - GROSS, not NET) $5,000 per month, you take the $5,000 per month and apply it to the non-deductible mortgage.

Then when you need money at the end of each and every month for the business to pay creditors, you borrow it (using the new equity in your house as security for a secondary charge of some sort). i.e. You use borrowed money to pay the business rent, pay the utilities, pay the wages, etc., by way of a floating chattel, or second charge.

You will likely have to pay 1% or 2% more interest to do this. But now the 16% interest on the $50,000 debt is DEDUCTIBLE. This means that you or your business pays from $2,000 to $4,000 less tax this year and next year and next year and next year.

I have seen situations where a business could reduce its GROSS by 54% and the owner would have more spending money because the interest is deductible.

If you are trading stocks, every time you trade, take ALL the profit plus principal and apply it to your mortgage. When buying new stock, borrow money for the purchase so that the interest is deductible. Use dividends received to pay down the mortgage and use the increased equity in the house to finance more stock or mutuals.

And do not tell me it is not worth it. Obviously, the self-employed person or heavy stock trader can manage this very quickly.

The following example shows how the owner of rental property can rearrange the deductibility of his interest payments quite quickly. I have assumed starting in January for simplicity's sake.

 

 

Example
YOU - a salaried employee earning $60,000 and in an effective 50% tax bracket (for easier calculation, depending on province or state, and city, it could be from 40% to 50%) buy two condominiums to rent out and apply the rent in a new and creative manner against your $50,000 mortgage at 15% on your house. In year one - you start off with $50,000, pay $8,000 in regular payments and apply $12,000 in gross rents from rentals to the mortgage.

Year ONE looks like this: $50,000 + 7,000 Interest - 8,000 Regular payment - 12,000 Extra payment leaves $37,000 outstanding on the house mortgage at 15%  plus you borrow $12,000 to make payments on your apartments. You have to pay 16% or $1,920 which is deductible so you get $960  tax refund. (For ease, I have assumed January to December calendar year.) Total borrowed about $49,000.

Year TWO looks like this: $37,000  @ 15% + 5,000 interest - 8,000 regular payment 12,000 extra payment = $22,000 outstanding on the home mortgage @ 15%  plus you borrow $12,000 more (total $24,000) @ 16% to MAKE APARTMENT payments, and have to pay a total of $3,840 which is deductible and you get back $1,920 as a tax deduction. Total borrowed approximately $46,000.

By the end of 42 months, you owe about $42,000 at 16% and the interest is deductible (i.e., 16% of $42,000 = $6,720 with a $3,000 tax refund).

The difference is - you were paying $8000/year (had to earn $16,000 and pay $8000 in tax to have the $8000 left over to pay the mortgage) - and now you are paying out only $6720 - 3,000 = $3720. You've put about $4500 back into your pocket in that third year and every year after that.

 

WORTH DOING? -- OF COURSE!

 

david ingram

 

The CEN-TA Group provides US / Canada Income Tax Advice, Preparation and Assistance in obtaining US working visas under the Free Trade Agreement (NAFTA)

 

Call us at (604) 913-9133 (toll free at 1-866-980-0499 anywhere in North America)
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