An Investment Loan and Excess Cash
Back in March 2009, I posted about what happens to the Smith Manoeuvre strategy once the mortgage is paid off. From that post, I listed 3 solutions:
- Keep the investment loan forever
- Pay off the investment loan over time
- Pay off a portion of the investment loan
For us, it will probably be a combination of 2 and 3 where we’ll pay off the investment loan over time, and perhaps keep a balance that we’re comfortable with. But there is something that I did not consider, that is, what do I do with the excess cash flow now that the mortgage is paid off? Providing that I’ve already budgeted for RRSP and TFSA contributions, there will be almost $2k/month in extra cash flow without the mortgage payment.
Being the capitalist that I am, my first thought is to continue contributing to my Smith Manoeuvre dividend portfolio with cash. However, as the portfolio is funded by an investment loan, there may be tax issues that I’m not aware of. With that, I consulted Tax Guy who concluded that …
Co-mingling cash contributions to your leveraged investment account “may” affect the deductibility of interest. Provided you can track each cash contribution, the worst case scenario would be a proportional split of the interest.
Assume you have fully paid off the instalment portion and end up with a HELOC of $200,000 and a portfolio valued at $300,000. At the beginning of the year, you place an additional $10,000 of cash in the brokerage account. The account earns 7% for the year and has a FMV of $331,700 at the end of the year.
The interest you can deduce should be in proportion to the amount of the account you have funded with the loan or 90.4%.
Again this would be a worst case scenario (provided you can always track each dollar). Best case scenario would that the CRA would allow you to deduct the full interest from the HELOC although this would get messed up if you decide to take funds out of the account. Withdrawals would most definitely affect interest deductibility.
I would recommend you use a separate brokerage account for cash investments and keep it separate from your leveraged investments.
So depositing cash directly into a leveraged portfolio isn’t a great idea, however, I really don’t want to open a brand new stock brokerage account to continue investing in dividends. I want to continue building my existing portfolio.
I then came up with an alternate solution – instead of putting the cash directly into the brokerage account, use the cash to pay down the investment line of credit, then continue using the investment line as buying opportunities occur. This way, the investment line of credit “should” remain fully deductible which was confirmed by CMA Ed Rempel.
Mr. Rempel points out that the main pitfall of using all your cash flow to pay down the investment loan to reinvest are not the tax aspects, but in the access to cash/capital.
Paying down the loan any time is fine and then reborrowing is just additional leverage. Basically, all that means though is that you are mixing your leveraged and non-leveraged portfolios. You understand that means that all your investments are leveraged, so you can’t cash in any of your investments without paying down the investment credit line.
That’s why I would suggest to keep a non-leveraged portfolio – so you have access to some money.
I can see how this would be an issue if we were to put 100% of our excess cash flow towards the leveraged portfolio, but we have a tendency to accumulate cash in a savings account as a nature of habit.
What do you think? Do you think I should open a separate account to avoid any tax issues? If you have a leveraged portfolio, what strategies do you use to keep a clear paper trail?