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The following is excerpted from my September 1998 CEN-TAPEDE
CANADIAN TRUCKERS MUST FILE UNITED STATES INCOME TAX RETURNS
I have being telling People who live in Canada and work in the
U.S. (bus drivers, airline personnel, business executives, etc.,
that they had to file a U.S. Federal and State returns if they
perform "any" duties in the U.S. Most of the time there is no tax
to pay, "BUT" You have to file the tax return to claim money free
of United State's income tax.
i.e. If you do not file the Income Tax Return to claim the
exemption and the IRS or States of California or New York or
Pennsylvania come along four years later, YOU WILL OWE tax on
money that may have been tax free.
I recently traveled to Newfoundland in a motorhome. There was a
leak in the left rear wheel seal and I bought a Canadian Trucking
magazine which had a "wheel seal" headline and I thought I would
learn what the truckers do about leaking wheel seals. To my
intense pleasure, there was an article by a Boston Lawyer about
U.S. Income Taxes being applied to Canadian truckers. The gist of
the article was that the United States are demanding income tax
returns from Canadian truckers back to January, 1992. Regular
readers of the CEN-TAPEDE will recognize that I have been stating
this fact for years. While I do not wish the problem on anyone,
it is no different from the letters I have reproduced here and Mr
Barry Lacombe's reference to American Airline pilots. Mr Lacombe
is an Assistant Deputy Minister of National Revenue.
If you are working in the United States for any amount for any
time, you are legally required to file a U.S. federal income tax
return even if all your salary or remuneration is paid by a
Canadian employer. You must also file a state return for 43
different states, even if paid by a Canadian employer. So, yes,
if you made sales calls in person to a company in Chicago and you
receive a salary, you are required to pro-rate that salary and
file both a U.S. 1040NR and an Illinois IL-1040. If there is an
income tax liability, Canada will give you a (usually) dollar for
dollar credit and it will not cost you more tax. It just spreads
the money around to where the work was performed.
This is different from the Canadian concept which usually (unless
self-employed in a different province) taxes you in the province
of residence.
However, in Canada, if you lived in Lloydminster, Saskatchewan
and had a self-employed business in Lloydminster, Alberta, you
would pay your provincial tax to Alberta at Alberta tax rates
because that is where the business was located. (this only
applies to self-employment as a proprietorship or partnership, it
does not apply if you receive a T-4 slip from an employer, even
if it is an Alberta Corporation that you own.
-----------------------------------------
Regular Readers of this will have just seen my client who was
assessed $71,000 back GST interest and penalties because he has
grossed between $30 and $60,000 every year since 1991, "should
have" been registered and charging GST but no one said anything
so he did not bother and thought "he was getting away with it".
It is an absolute that the IRS can go back to 1967 if they find a
Canadian who was working in the USA and not filing a US tax
return. This includes Truckers, salespeople, installers and
anyone else who goes into the US to perform services for his or
her Canadian employer. If a trucker earns less than $15,000 US,
there is never any tax. Over $15,000 (over the whole year) there
could be tax if the ownership of the company happens to have an
American base or if the IRS can trace the eventual salary back to
a US entity.
Other occupations are exempt federally if they earn less than
$10,000. So if you earn $7,000 a month and spent three months or
so all together in the US, YOU HAVE to file a US return. One
client received a "collectible" $184,000 bill going back 9 years.
It cost Michael L his wife, his house, his Porsche and almost his
sanity.
If your employer tells you to forget about it; "no one does
that", look at the Canadian $71,000 assessment for eleven years
back that I just sent out two days ago.
The following is my November 2001 newsletter which I am including
here. After you see who "has" to do a US tax return, you can
read the rest of it and learn how to make your CANADIAN mortgage
deductible on your CANADIAN tax return
Nov 08, 2001
The CEN-TAPEDE
david ingram's US/Canadian Newsletter
108-100 Park Royal South, West Vancouver, BC, V7T 1A2
(604) 913-9133 (9 AM - 5 PM) - Fax 913-9123
DID YOU KNOW? -- TAXATION IS BASED UPON WHERE YOU WORK - NOT
WHERE YOU LIVE.
Canadians performing services in the United States, and in 43 of
the states in particular, are required to file the respective
state return(s) and a US federal 1040NR or 1040 income tax
return, even if their remuneration was paid from Canada. This
applies, but is not limited to:
* Executives attending meetings in the US and, in particular,
California,
* Service technicians servicing Canadian products under
warranty,
* Salespeople selling Canadian products in the US,
* Journalists (eg. covering Canucks Hockey games, INDY races or
O J Simpson trial),
* Horse trainers, race car mechanics
The above are exempt from tax up to $10,000 of earned income but
the taxpayer must file returns to prove his or her exemption per
Article XV. If you earned over $10,000 in the US, US taxation
depends on where the employer gets its ultimate tax deduction for
the wages paid out. If you are in the US more than 183 days, you
are usually taxable on your world income.
** Entertainers, actors, musicians, performers,
** Professional athletes, race car drivers,
jockeys.
The above are exempt from tax up to $15,000 in gross earned
income (which includes travel expenses) but still have to file
the return to prove their exemption under Article XVI.
*** Transport Employees, Truckers, Flight Attendants, Pilots if
over $15,000.
Transportation employees are exempt from tax in most cases even
if in the US for more than 183 days, if they are exercising their
regular employment. They must, however, file the tax return to
exempt the income.
With Chartered Accountants, US Lawyers, and US CPA's as
associates, I feel that the CEN-TA Group has the experience and
the qualifications to look after most, if not all, US / Canadian
tax problems.
Contact George Hatton, CA, Sonja Clark, CA, CPA, LLB, D'Arcy von
Schleinitz, David Ingram, or Gail Ritter at (604) 913-9133 - Fax
(604) 913-9123 for US and CANADIAN INCOME TAX PREPARATION,
ACCOUNTING and / or CONSULTATION.
Contact David Ingram for US Working Visas.
MORTGAGE INTEREST AS A DEDUCTION
People usually think that Americans have it all because they can
deduct their mortgage interest and property tax on their income
tax return. This is true. They can make these deductions, but
to do so, most families give up a $7,000 standard deduction.
This is fine if your mortgage interest is over $5,000 or so, but
the practical fact is that 90% of mortgages in the US are $50,000
or less and interest on $50,000 isn't enough to justify giving up
the standard deduction.
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 attaché
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 Customs and Revenue Agency (CCRA), 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 $55,000 per year and are on
the edge of a 45% marginal tax bracket. You take a business trip
from Vancouver to Victoria. It costs $100 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 $175. If you do not
keep these deductible receipts, you might just as well have torn
up a “seventy-five” dollar bill and thrown the pieces overboard.
At least most of that trip was deductible. Even though you spent
$175, you got $75 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 also 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.
Twenty-two 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 our mortgage interest deductibility involved
purchasing some rental real estate (you need an outside source of
income). I am proud to say that as well as making the house
mortgage deductible, in most cases the rental real estate has
gone 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's
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 Tax Credits (SRTC) 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.
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?
The 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 (Joan
Marsh) 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 by Hancock House Publishers Ltd.")
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 do not, we could and will arrange for you to buy it and
manage it for you and set up the following program). That rental
property might be the first MURB you bought or even 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, 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 works 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 today, Nov 8, 2001, I can
get a mortgage in the 4 or 5% range and that most Vancouver
mortgages are 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', also by HANCOCK HOUSE and
available `ahem' in `better' book stores - not now - try the
Library.)
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 about $6,500 to have the
$7,500 left over for the non-deductible interest payment. If you
have a business grossing $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 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 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 - 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%) buys two
condominiums to rent out and applies the rent in a new and
creative manner against the $50,000 mortgage at 15% on his house.
(In year one - he starts off with $50,000, pays $8,000 in regular
payments and applies $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 = $37,000 O/S at 15% plus
borrows $12,000 to make payments on Apartments, and has to pay
16% or $1,920 which is deductible = gets $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 O/S @ 15% plus
borrows $12,000 more (total $24,000) @ 16% to MAKE APARTMENT
payments, and has to pay a total of $3,840 which is deductible
and gets back $1,920 as a tax deduction. Total borrowed
approximately $46,000.
By the end of 42 months, we 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).
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)
More information can be found at www.centa.com.
Call us at (604) 913-9133
Fax us at (604) 913-9123
Or email me at [email protected] for more information
david ingram - [email protected]
108-100 Park Royal South
West Vancouver, BC, CANADA, V7T 1A2
(604) 913-9133 - (604) 913-9123 www.centa.com
Cell is (604) 657-8451 (10 AM to 10 PM seven days a week)
US / CANADA / MEXICO
Working Visa and Income Tax Specialists
Be ALERT, the world needs more "lerts"
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