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Key Tax Considerations on an Investment Loan!

As I have been considering implementing The Smith Manoeuvre, I have been doing some research on the taxation benefits and how to make sure that all interest payments stay deductible. I came across some important taxation points that I thought I would share with you.

Calculate your interest deductible:

  • To determine the tax return of the interest paid on your investment loan, multiply the total interest paid during the year by your marginal tax rate.
  • For example: if you paid $1,000 in interest for the year and you are in the 40% marginal tax bracket, you will receive $400 back from the government.

CCRA Rules:

  • Canada Customs and Revenue Agency (CCRA) expects that if you use borrowed money to invest that you will receive some sort of income from your investments. The “income” includes interest, dividends, rent and royalties. Even if a stock that you purchase does NOT currently pay dividends, as long as they have a reasonable “expectation” of future dividend payments, then it “should” remain deductible.
  • Although CRA only expects income from your investment portfolio, in 2003, the finance department declared that in order for investment loans to remain deductible, the interest/dividends must produce a profit. That is, the dividends must EXCEED the interest that you are paying on the loan. I know, the finance department and the CRA are on different pages. According to Tim Cestnick, the CRA will generally ignore the finance department rules and accept the tax deduction as long as it produces income, but check with your tax professional for the latest rules.

Keep your interest deductible!

  • Once you use a loan/line of credit to invest, do NOT withdraw from it unless it is from dividends/interest that the investment produces.
  • For example, if you use a $10,000 line of credit to invest, achieve a $5,000 capital gain, and withdraw $5,000 to spend on a vacation. How much of your loan balance is still deductible? $10,000? Nope! According to Tim Cestnick, since you withdrew 1/3 from your investment loan, only 2/3 of your remaining loan is tax deductible.
  • This includes Return Of Capital funds/income trusts also! Technically, as you receive ROC distributions, it will decrease the tax deductibility of the investment loan . This can be avoided by using the ROC to pay down the investment loan, then re-investing if desired. Technically, this “should” be the same as simply leaving the ROC distributions in the investment account (confirm with your accountant).
  • If you gain $300 (or any amount) in dividends though, you can withdraw $300 and spend it as you please. If you’re using an investment loan to perform the “Smith Manoeuvre“, I would suggest to use the dividends to pay down the non-deductible mortgage to further accelerate the conversion to deductible/good debt.

Summary:

  • Make sure your investment loan produces income of some sort.
  • If you are going to withdraw from your investment loan to spend, make sure you only withdraw an amount equal or less than the dividends/interest produced in the account.
  • ROC distributions are undesirable for leveraged investment accounts as they decrease the tax deductibility of the investment loan. There are ways around this, but it can turn out to be an accounting/paper trail nightmare.
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FrugalTrader About the author: FrugalTrader is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.

{ 182 comments… add one }

  • CD March 6, 2013, 7:34 pm

    Ed – thanks for the reply! Your interpretation is the one I was looking for. Cheers, CD

  • Michael March 18, 2013, 11:28 pm

    Hi FT or Ed,

    Thank you for the informative posts. I have a question for you guys:

    I’m still not too clear on the ROC concept, from what i gather some ETFs does this so the amount of ROC will no longer be claimable for tax credit.

    Can you let me know if ZWB is affected by this “ROC”?

  • Nikolai April 4, 2013, 1:10 pm

    Hi,

    Looks like there is no clear answer to this question (until you get to the real argument with CRA, I guess ;) ) but I would like to confirm my current understanding of the interest deductibility for the investments like REITS.

    1. Say, I buy X units of a REIT (IIP.UN or something else). I use borrowed money from HELOC to fund the purchase.

    2. Every distribution I receive I carefully send back to the credit line, down to last penny.

    3. I believe that the declaration of trust for most of the REITs never say specifically that “we will pay you ROC and only ROC, you will never get any interest or dividends as distribution”. Thus, I think this investment should be considered qualified by CRA. The goal of REIT is to earn rental income and pay it to the shareholders in the most tax-efficient form they can, but that does not mean 100% no taxable returns ever.

    4. Obviously, once the ACB is down to 0 a few years later I would start paying capital gain taxes on ROC portion of the distributions.

    5. When I sell it, I repay back at least the amount that is equal to the current ACB of my stock (assuming I have not lost money) back to HELOC.

    So, using this logic – do you think it is sufficient to be able to convince CRA that the interest is indeed deductible should they start questioning it?

  • FrugalTrader FrugalTrader April 4, 2013, 1:48 pm

    @Nikolai – I do not see any problems if you withdraw distributions to pay down your investment loan. Just sure to keep track of your adjusted cost base at year end.

  • Ed Rempel May 18, 2014, 1:48 pm

    Hi Nikolai,

    FT is right. If 100% of the distributions are either paid onto the loan or reinvested and you can prove that, then the tax deductibility of the loan should not be in question.

    With REITS, you don’t know how the distribution will be taxed until several months after the year-end, so it is definitely best not to withdraw the distributions for any other purpose. The math of calculating how much of your loan is still deductible would be complicated.

    We don’t have that issue with corporate class mutual funds. The distributions vary, but are 100% capital gains, so we can do whatever we want with them.

    We almost always reinvest them anyway (since the goal of the Smith Manoeuvre is to build a large nest egg for your future without using your cash flow).

    Ed

  • Brown May 28, 2014, 2:23 pm

    Great article here
    The above help surely helped me make up mind about my problem
    Thanks again

  • Suprbeast June 23, 2014, 1:09 am

    Great resource, lots of great information. I have a couple more questions. I understand that I can’t just take money out of the leveraged investment account for non investment spending without seriously impacting the deductibility.

    But:

    1. Can I sell the leveraged investments and then re-invest those funds in something else that produces dividends? i.e. rebalancing a portfolio. I’m assuming yes, but wanted to confirm.

    2. Can I sell the leveraged investments and use the cash to invest into my own small business (which ‘pays dividends’).

  • Monica November 14, 2014, 2:12 pm

    What is the best use of my HELOC? Should I invest it in income-producing investments and then put the proceeds in RRSP? Or should I use it to invest in mutual funds? What will the optimal answer depend on?

  • lois January 26, 2015, 4:30 am

    Hi, I have a question about the eligibility of interest on borrowing usd in margin account. Does the american dollar interest qualify for tax deduction.

  • Tito March 17, 2015, 11:56 am

    Hi,

    I have a question regarding investment loan on interest tax deductible. I’ve been investing in Mutual Fund with T8 series since 2010, I borrowed 150k with 50K of my capital, total invesment= 200k. I receive ROC 8% every month and i do not reinvest. Each of the year i receive the statements from the investment lending service, one statement indicates the interest paid 5250$ for each year end and the balanced of borrowed money 150k. My question is, when i file the income tax for the year 2014,and my ACB is136K, do i still file the interest payment of 5250$ on 150k as indicate in the statement of 2014? Or do i have to calculate manually?

    Thank you!

  • Ed Rempel March 17, 2015, 10:19 pm

    Hi Tito,

    You are doing the Smith Snyder strategy. There are tax issues. Unfortunately, I have a few pieces of bad news for you. You need to manually calculate the amount of interest that is still deductible.

    So you understand the concept, if you borrow $100,000 to invest and then cash in the investments, the loan is no longer tax deductible. Receiving the ROC (return of capital) is the same thing. You are taking your original amount invested out of the investments.

    In short, all the ROC payments you received reduced the amount of your investment loan that is tax deductible.

    In rough numbers, you have received $16,000/year for 5 years, or $80,000. That is 40% of the $200,000 you invested, so 40% of your loan is no longer tax deductible. If you multiple the $5,250 interest you paid by 60% (the amount still deductible), you should be able to claim roughly $3,150.

    Your deduction could be higher depending on how you paid the interest on the loan or on any T3s or T5s you received for these investments. If you used part of your ROC to pay the interest (and can trace it) or if part of it was taxable (and not ROC), then your tax deduction should be more.

    It also sounds like you claimed too much for the past 4 years, You should really adjust those past years.

    The other thing you should know is that the ROC stops after 12.5 years (7 or 8 years from now). At that point, your ACB will reach zero, so all the payments you received will be capital gains. In addition, when you sell, the entire proceeds are a capital gain (since the ACB will be zero).

    There are several options to fix this, if you want. What are you doing with the ROC payments? Do you need the monthly income for something?

    You can reinvest the ROC (or reduce it to the amount of the interest) and crystallize the capital gains up until this point. You could also convert to doing the Smith Manoeuvre instead, which means you don’t have to do the manual interest calculations (and it is a more robust strategy with other options).

    Sorry to give you the bad news, Tito.

    Ed

  • Tito March 18, 2015, 12:46 am

    Hi Ed Rempel,
    Thank you for the respond! Yes I do receive ROC part of it to pay the interest only and the other to pay my mortgage.

  • Tito March 18, 2015, 1:52 pm

    If half of my Roc is paid to the investment loan ( interest only),is that portion still tax deductible?

  • Matthew Mantle March 19, 2015, 5:48 pm

    Hi FrugalTrader and Ed,

    I’ve been getting closer to the start-date of my Smith Manoeuvre strategy getting underway (had to wait for the mortgage to hit a maturity date) and I notice that on March 6, 2015, there is now a new Folio from the CRA (S3-F6-C1 – http://www.cra-arc.gc.ca/tx/tchncl/ncmtx/fls/s3/f6/s3-f6-c1-eng.html) which is meant to update and replace Bulletin IT533, which addressed Interest Deductibility. I’ve read it through, and you can see the effects some of this Smith Manoeuvre strategy has had on the tax code!

    I am not a tax expert, my line of work is in planning and investments, but it seems to me this is meant to give some clarity on a few major points we should care about.

    1.35 – tells us that current use of dollars is the relevant use to determine deductibility

    1.38 – tells us we have the ability to split dollars out between investments and maintain proportion for same-value and capital gain positions, but ONLY use deductibility on the original loan amount (makes sense). This would seem to me to be an opportunity for someone in the midst of converting bad debt (mortgage) to good debt (loan) to remove the capital gain from the investment account, use it (alongside dividends and interest) to reduce the principal of the mortgage in a lump-sum payment, and create new space on the loan to reinvest. That way you are increasing deductibility and reducing bad debt at the same time, instead of simply immediately reinvesting the higher amount.

    1.39 – confirms that where something is sold at a capital loss, the dollars can be reinvested, and the original loan amount is still considered fully deductible. I guess you never want to repay the loan with loss-dollars then, because they’re proportionately more valuable when left outstanding.

    1.40 – this seems to be a bit of a clarification on the RoC issue. Though they don’t state it explicitly (I’m going to suggest during this comment that they do state it explicitly in an example) that we could invest in things that pay out RoC (ex. REITs) and hold on to the payments when they’re made through the course of the year. Once the final RoC split is announced, take that amount, pay back the loan in that amount, and then reinvest to re-establish the loan on that portion. Alternatively, it sounds like taking anything paying regular RoC and putting it onto a DRIP would maintain the ‘current use’ definition throughout the life of the loan without so many mechanics to worry about.

    1.69 – FINALLY! Something specific from the CRA that I was concerned about. “where an investment carries a stated interest or dividend rate, the income earning test will be met…, …interest will neither be denied in full nor restricted to the amount of actual income from the investment where the income does not exceed the interest expense.” Right on! Clearly stated full deductibility for all investments…except…

    1.70 – If a corporation doesn’t pay a dividend, and it has explicitly said it WILL NEVER pay a dividend (ex. Berkshire Hathaway), then the purpose test for deductibility will not be met. Too bad. However, “if a corporation is silent with respect to its dividend policy…the purpose test will likely be met”. Hmm, a bit ambiguous, but we should be investing for income anyways, right?

    There’s a bunch more that addresses Cash Damming and specific personal and corporate situations and some specific exclusions too, but I feel a lot more comfortable with my plan now!

    Now…please feel free to compare my interpretations to yours and tear any holes in my assumptions to shreds? I think that’d be good for all of us…

    MM

  • Ed Rempel March 21, 2015, 7:49 pm

    Hi Tito,

    Yes, if you use your return of capital (ROC) payment to pay the interest (and can track it) on your investment loan, then that portion does not reduce the tax deductibility.

    My suggestion would be to invest half in a fund that does not pay out the ROC and instead reinvests any distribution. Then only use the ROC payment to pay the interest.

    There is no benefit whatsoever in using any ROC to pay down your mortgage. In fact, you are losing money every month with this. You are converting the higher interest investment loan to non-deductible.

    For example, you pay $1,000 onto your mortgage which is at 2.5%. That means $1,000 of the investment loan at 4% is no longer tax deductible. After making this extra mortgage payment, you are worse off.

    There was a big marking campaign to sell this as a smart strategy years ago, but there is no benefit at all from using your ROC payment to pay down your mortgage.

    Ed

  • Ty March 23, 2015, 9:11 pm

    Hey guys,

    If I invest in a US held foreign etf which pays ROC in addition to dividends, will I be able to withdraw the entire distribution to pay down the mortgage and maintain the deductability of the HELOC. Assuming the distribution is treated entirely as foreign income as required by CRA.

  • Tarun April 25, 2015, 4:23 am

    Hey Guys,
    I am planning to do a DIY Smith manouvre (to minimise fees and other taxes) with minimal hassles. I would like to know if BRK would be an eligible investment for my strategy?
    Else what should be my strategy for a rental property?
    Also Should I proceed with capitalisation of interest OR pay it myself? (I can pay interest from my pocket- at least for initial few years)

    • FrugalTrader FrugalTrader April 25, 2015, 9:22 am

      Tarun,

      My understanding is that if BRK has in their mandate that they will “never” pay a dividend, then they would not be eligible. It’s really up to you whether or not you capitalize the interest on your rental property. Have you considered just keeping it simple and using the rent to pay down the rental mortgage?

  • Ed Rempel April 26, 2015, 1:09 am

    Hi Tarun,

    My understanding is that Berkshire Hathaway is allowed to pay a dividend, but Warren Buffett chooses not to. The tax rule is that generally only investments where their prospectus prevents them from paying dividends would be excluded as leverage investments. Buffett believes that companies should use their capital first to reinvest in their business, second for positive acquisitions, third for share buybacks, and then only if there is no opportunity in the main 3 uses of cash should they pay a dividend. In short, I believe it is acceptable.

    If you are trying to minimize tax, then you should obviously capitalize the interest. That may or may not make sense in your situation, but capitalizing the interest is definitely more tax-efficient. You can use your cash to invest, which is probably a better use than paying 2.2% tax deductible interest.

    Ed

    • Matthew Mantle April 26, 2015, 1:53 am

      Ed,

      The problem is that Mr. Buffett has very explicitly said that BRK will never pay a dividend, very publically, on a number of occasions. Since he’s Chairman, President, and CEO, you run into an issue with the new CRA Folio S3-F6-C1 which specifically prohibits deducting interest in shares where there is a Corporate policy against paying dividends, since there is no reasonable expectation of making income from the investment (section 1.70).

      Now, whether or not the CRA will challenge you on it is another issue…but do you really care to take the risk?

      MM

      • Matthew Mantle April 26, 2015, 2:01 am

        I suppose I should clarify that Mr. Buffett has always left himself an out…in the early days of BRK (1967)he claimed he was in the washroom when the dividend was approved, and more recently in 2012 (when he dedicated 2000+ words of the shareholder letter against the payment of dividends) he still did say they might reconsider that stance if there were nothing else possible whatsoever…which in his long career he has never been in the situation of considering.

        So yes, by definition, it’s not an explicit anti-dividend policy on record…just a potential argument waiting to happen with an ornery auditor I suppose

  • Tito May 7, 2015, 7:11 pm

    Hi, if I were to borrow and invest in a corporate class mutual fund , would my interest on the loan be deductible? As corporate class will generate capital gain…

  • Ed Rempel May 9, 2015, 2:10 pm

    Hi Matthew,

    Buffett does not pay a dividend because he doesn’t think it’s a good idea, not because there is anything preventing him. In fact, there was a motion to pay a dividend last year at which 97% of shareholders voted against the dividend. Everyone is confident that Warren can reinvest that money more effectively than they can.

    Warren’s position is that companies should only pay a dividend if they do not have a better way to use the money. They should first look at ways to invest effectively in their own business, then they should buy other businesses if they can effectively, then they should buy back their own shares if their are cheap. Only if there is no opportunity in those 3 areas, should they pay a dividend.

    Bottom line, there is nothing preventing Berkshire from paying a dividend if they wanted to, so interest on borrowing to invest in Berkshire should be deductible. With a price of over $220,000 US per share, many people would find it hard to buy the shares within a portfolio any other way.

    Ed

  • Ed Rempel May 9, 2015, 2:17 pm

    Hi Tito,

    Yes, the interest should be deductible investing in corporate class mutual funds. If you choose them well, you may be able to invest for decades with hardly any taxable distributions at all, but there is nothing in their prospectus that prevents them from paying distributions, so you should be able to deduct your interest every year.

    This has been our strategy. Our clients usually have a net tax refund from investments virtually every year – even after decades and after they retire and are taking income from their investments.

    We try to defer all dividends and capital gains as long as possible. There are special features (such as the “capital gains refund mechanism”) that make this possible.

    Ed

    • Tito May 11, 2015, 3:16 pm

      Thank you ED for the information.

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