Creating a Tax-Deductible Canadian Mortgage – Mortgage Advice
The tax law for Canada's homeowners is very different from the system in the U.S. Notably, the interest on a mortgage for a principal private residence is not tax deductible. However, all capital gains upon selling the home are tax exempt.
But there is a way Canadians can effectively deduct that mortgage interest.
The Financial Goal
First, a couple of basic definitions:
Your net worth is your assets minus any liabilities. To increase your net worth, you must either increase your assets or decrease your liabilities, or both.
Your free cash flow is the amount of cash that is left over after all expenses and debt payments have been made. To increase your cash flow, you must spend less, get a better paying job, or pay less tax.
Let's take a look at a strategy to help you increase your assets by building an investment portfolio, decrease your debts by paying off your mortgage faster, and increase your cash flow by paying less tax. Effectively, you would be increasing your net worth and cash-flow simultaneously.
Every time you make a mortgage payment, a portion of the payment is applied to interest and the rest is applied to the principal. That principal payment increases your equity in the home and can be borrowed against, usually at a better rate than an unsecured loan.
If the borrowed money is then used to purchase an income-producing investment, the interest on the loan is tax-deductible, which makes the effective interest rate on the loan even better.
This strategy calls for the homeowner to borrow back the principal portion of every mortgage payment, and invest it in an income-producing portfolio. Under the Canadian tax code, interest paid on monies borrowed to earn an income is tax deductible.
As time progresses, your total debt remains the same, as the principal payment is borrowed back each time a payment is made. But a larger portion of it becomes tax-deductible debt. In other words, it's "good" debt. And, less remains of non-deductible debt or "bad" debt.
To explain this better, refer to the figure below, where you can see that the mortgage payment of $1,106 per month consists of $612 in principal and $494 in interest.
As you can see, each payment reduces the amount owed on the loan by $612. After every payment, the $612 is borrowed back and invested. This keeps the total debt level at $100,000, but the portion of the loan that is tax deductible grows by each payment. You can see in the above figure that after one month of implementing this strategy, $99,388 is still non-deductible debt, but $612 is now tax-deductible.
This strategy can be taken a step further: The tax-deductible portion of the interest paid creates an annual tax refund, which could then be used to pay down the mortgage even more. This mortgage payment would be 100% principal (because it is an additional payment) and could be borrowed back in entirety and invested in the same income-producing portfolio.
The steps in the strategy are repeated monthly and yearly until your mortgage is completely tax deductible. As you can see from the previous figure and the next figure, the mortgage remains constant at $100,000, but the tax-deductible portion increases each month. The investment portfolio, on the side, is growing also, by the monthly contribution and the income and capital gains that it is producing.
As seen above, a fully tax-deductible mortgage would occur once the last bit of principal is borrowed back and invested. The debt owed is still $100,000; however, 100% of this is tax deductible now. At this point, the tax refunds that are received could be invested as well, to help increase the rate at which the investment portfolio grows.
The goals of this strategy are to increase cash flow and assets while decreasing liabilities. This creates a higher net worth for the individual implementing the strategy. It also aims to help you become mortgage-free faster and to start building an investment portfolio faster than you could have otherwise.
Let's look at these a bit closer:
- Become mortgage-free faster. The point at which you are technically mortgage-free is when your investment portfolio reaches the value of your outstanding debt. This should be faster than with a traditional mortgage because the investment portfolio should be growing as you make mortgage payments. The mortgage payments made using the proceeds of the tax deductions can pay down the mortgage even faster.
- Build an investment portfolio while paying your house down. This is a great way to start saving. It also helps free up cash that you might otherwise not have been able to invest before paying off your mortgage.
A Case Study
Here's a comparison of the financial impact on two Canadian couples, one paying a mortgage off in the traditional way and another using the tax-deductible strategy.
Couple A bought a $200,000 home with a $100,000 mortgage amortized over 10 years at 6%, with a monthly payment of $1,106. After the mortgage is paid off, they invest the $1,106 that they were paying for the next five years, earning 8% annually.
After 15 years, they own their own home and have a portfolio worth $81,156.
Couple B bought an identically priced home with the same mortgage terms. Every month, they borrow back the principal and invest it. They also use the annual tax return that they receive from the tax-deductible portion of their interest to pay off the mortgage principal. They then borrow that principal amount back and invest it. After 9.42 years, the mortgage will be 100% good debt and will start to produce an annual tax refund of $2,340 assuming a marginal tax rate (MTR) of 39%. After 15 years, they own their own home and have a portfolio worth $138,941. That's a 71% increase.
A Word of Caution
This strategy is not for everyone. Borrowing against your home can be psychologically difficult. Worse, if the investments don't yield expected returns this strategy could yield negative results.
By re-borrowing the equity in your home, you are also removing your cushion of safety if the real estate or investment markets, or both, take a turn for the worse.
By creating an income-producing portfolio in an unregistered account, you may also face additional tax consequences. You should consult with a professional financial advisor to determine whether this strategy is for you. If it is, have the professional help you tailor it to you and to your family's personal financial situation.