November 2001 CEN-TAPEDE - Taxation based on where you work, mortgage tax deductitble, Canada vs US, Mortgage Interest Part II

This is Part II of the two part November 2001 Newsletter - Part I is here


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.





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.




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.




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.




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.




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".




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.




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.




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).





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)



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The following comments are owned by whomever posted them. This site is not responsible for what they say.
Authored by: Tom on Monday, January 04 2010 @ 05:23 PM PST November 2001 CEN-TAPEDE - Taxation based on where you work, mortgage tax deductitble, Canada vs US, Mortgage Interest Part II

I think I have it!


If my business grossed $100,000 and I had $50,000 in expenses, at the end of year one I would have $50,000 of debt in the busines line of credit. ($100,000 the second and $150,000 the third)


Would I pay personal income tax on only 50,000?  Or would I have to pay on the full $100,000 because I took it all and used it all for personal expenses?



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