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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.




170 Comments, Comment or Ping

  1. This is great content Frugal! I like the comment on making sure your investment loan produces income. It is a “duh” sort of thing, but it wouldn’t surprise me if tons of people don’t take it into consideration!

  2. 2. Warren

    Great article. People (like me until recently) seem to think nothing of borrowing hundreds of thousands to purchase real estate, why not borrow a few thousand to buy some blue chip stocks?

  3. Hey Milliondollarjourney…
    Thanks for dropping by http://www.canadian-money-advisor.ca and expressing interest in the Canadian Tour of Personal Finance blogs!! It’s going to be good.

    I will let you know what’s going on as things develop.

    I am putting together a formal signup sheet and info page today so that we can collect information in our system.

    Please do tell your other Canadian personal blogging friends about our Tour.

    I think we need about 6-7 more people to complete the first tour.

    Canadian personal finance bloggers are GOOD!!

    Thanks again.

    Monty Loree

  4. 4. Jon Lee

    Ahh very nice, this is the kind of stuff I like learning about :)

  5. 6. Manny

    Hi FT,
    I have a line of credit(LOC) that I planning to use for buying stocks. How does one prove that the loan was actually used for income generating purpose? I mean.. what kind of paper trail is needed? Do you actually deposit the cheque from the LOC account and deposit it directly to the brokerage account and keep the receipt? While I understand basic idea of using the loan for generating, I am just trying to under the mechanics of execution. Also, would your interest payment be tax deductible if you invest in RRSP account ?

    Thanks in advance for your tips!
    Manny

  6. Manny, it’s best to contact an accountant with regards to the papertrail needed. To me though, it would suffice to keep your LOC records that show money tranferring out of the account, and perhaps records from your brokerage the same amount going into the account. Those records should be easily retrieved electronically.

    With regards to your RRSP, no, you cannot deduct the interest on a LOC if you deposit the funds into an RRSP.

  7. 8. Cannon_fodder

    FT,

    What about this idea? Borrow money to invest in some nice blue chip dividend Canadian stocks. Pay the interest, claim the deduction. Take the dividend income and deposit that into an RRSP. The dividend income should be at a higher (sometimes much higher) marginal tax rate when redirected to an RRSP contribution rather than kept as income.

    So, if you are in Ontario at 46.41 % MTR, a 6.25% LOC actually costs you 3.37% factoring in the tax refund. If you could structure a portfolio that yielded 4.5% then the income after taxes would pay the LOC interest costs completely because it would be taxed at 24.64% but the contribution would return a refund of 46.41% of the contribution.
    (I know that could take time as there aren’t a lot of quality dividend producing investments that are over 4%. You would be selecting stocks which had 5 years of increasing dividends that are also at least 3% now, hoping that in a few years they would get to the magical level.)

    This is off the top of my head… is this sound?

  8. 9. Cannon_fodder

    Well, I mashed two ideas in my head and out came confusion. A yield of about 4.5% would allow one to take the dividend income, net of taxes, and pay the LOC cost, net of tax refunds.

    Above that yield, you would then have a net positive situation. To take the dividend income and contribute ALL of it to the RRSP and expect that the refunds would pay the interest cost in the example, you would need almost 15.5% yield on your original investment! That would take a long time even with banks like RY raising their dividends on an annual average of 18.5% over the last 5 years (meaning it would be about 9 or so years).

    That would be an interesting situation – having a dividend payout that you could contribute to your RRSP and after all the tax machinations, you end up with a tax refund paying for all the costs associated with the investment loan.

  9. These are some interesting scenarios that you have come up wtih CF. Perhaps you could implement these scenarios into your program! :)

    On one hand, you have a larger RRSP contribution which results in a larger tax return. Except with dividend contributions, you’ll end up getting more back than you paid in income tax due to low taxation of dividends.

    With the mortgage, you get a guaranteed return of your mortgage rate.

    It would be interesting to do some calculations as to which is more efficient at certain tax brackets, interest rates etc.

  10. 11. Cannon_fodder

    FT,

    Yes, I’m thinking another calculator may be of some value.

    Realistically, I don’t think the concept of putting the dividend income into the RRSP makes a lot of sense. Sure, the growth can compound tax free, but in most cases you will be withdrawing the dividends and their resultant growth at a higher marginal tax rate than if you simply paid the taxes initially. In the highest tax brackets, perhaps it is worth considering, but there are instances where the dividend MTR is negative.

    Perhaps a calculator showing the various scenarios would make it more clear…

  11. CF – some interesting thoughts.

    With respect to whether it makes sense to put dividend income from non-registered stocks into an rrsp, my opinion is that the source of the income is irrelevant to the decision of where or how to invest the income.

    Mike

  12. 13. nobleea

    I have a question for all here to do with tax deductibility of interest.

    Example: You have a 500K house with a 250K fixed mortgage. You opened a HELOC for 125K and used that money to invest in stocks, non-reg. The interest from this HELOC is tax deductible (for the most part). You got lucky on the stocks and in a year or two, your stocks are worth over 300K.

    You sell all the stocks, pay the capital gains hit, and then pay off your mortgage with the remaining. Then you replace it with another HELOC and use it for investment purposes.

    Is the interest on both HELOCs tax deductible? They are both used for investment purposes, though if you want to get technical, you used some of the first HELOC to pay off the mortgage, which would not be tax deductible?

  13. 15. Ed Rempel

    Hi Noblea,

    I just noticed your post. Yes, both credit lines would be deductible.

    If you sell your investments, you need to pay the amount invested down on the credit line, but the taxable profit can be used for any purpose, including paying off your mortgage. You borrowed $125K to invest and then paid off the credit line when you sold your investments, so you are fine.

    The 2nd leverage is a new leverage, so it should be deductible as well.

    Ed

  14. 16. Trump Jr

    FT;

    Some excellent info. I have a question about the requirement to “receive some sort of income from your investments”. I am considering loan for
    investment in a mutual fund from CI, a new T-class fund with no annual distributions, just a monthly payout represented as return on capital (5% or 8%). At some point in the future, I will redeem it and trigger capital gains. Would I be eligible for tax deduction on interest on loan for this type of investment?

  15. Trump, I highly discourage the idea of buying a ROC fund through an investment loan. The reason being is that with every ROC distribution, your tax deductibility of your investment loan will be reduced.

  16. 18. AJ

    I have been looking for places to obtain an investment loan at a reasonable rate. I haven’t applied for anything yet because I don’t want too many applications on my credit report. Recently one of my credit card companies sent me cheques (the usual attempt to get more interest our of their customers) The rate is actually quite low so I was wondering if a credit card advance would qualify as a tax deductible investment loan…

  17. 19. nobleea

    Yes, a cash advance from a CC would be valid as long as the interest rate is in line with other investment loans. CRA would frown upon an investment loan at 28% interest! An investment loan can be from a bank, credit card, line of credit, friend, family member, anything, as long as it has valid repayment terms, reasonable interest, and is used for investment purposes.

  18. 20. SH

    I have a LC from which I would like to invest. However RBC requires that I transfer money from my LC to my checking account and from there to my RBC direct investment account and from there I can invest. What is required in order to be able to prove that it was the money borrowed from the LC that ultimately was used to invest. I checked with RBC if my LC could be linked to my direct investment account but was informed that this is not possible. Any help would be appreciated.

  19. 21. Ed Rempel

    Hi Sh,

    Did you choose this name because you don’t want anyone to know what you are saying???

    The issue here is traceability. Can you trace the money from the credit line going to the investments. If you transfer to your chequing account and then invest the exact amount (to the penny) on the same day, then you should be fine.

    Ed

  20. 22. SH

    Hi Ed:

    Just initials of my name. Did not realize they could be taken in a different context. :)

    Thanks for your clarification on my question.

  21. 23. rolando

    Hi guys, it’s amazing what you guys talked about here,it’s an eye opener ,not too many people knows about SM .Here is a scenario… I have an Aunt who’s been retired and is sitting on a home that has been paid up for 7 yrs. She pays taxes on her pension income and her house is worth about 200k. How can we go about or how do we start applying this concepts and what do we need to do to execute this? I just want to help thanks!

  22. 25. AMeer

    Beautiful…

    Can you please tell me an example with Return of Capital….
    suppose i toke a investment load of $50,000 and invested in ROC funds.
    I am getting $600 distribution every month. I am paying interest only.
    after 7/8 years when ROC is zero still i can show my interest in my Tax ?

    or how i will calculate my Loan interest on investments

    Ameer

  23. 26. DAvid

    AMeer said: “I am paying interest only.
    after 7/8 years when ROC is zero still i can show my interest in my Tax ?”

    No. You reduce your tax deduction on interest at the same rate you deplete your principal amount. So in the first year, about 1/7th of your interest paid is no longer deductible, increasing in year 7 to being 100% of your interest being non-deductible. Have a look in the Smith Manoeuvre thread for more discussion on this.

    DAvid

  24. 27. Ed Rempel

    Hi AMeer,

    In addition to losing the interest deductibility each year as David mentioned, the ROC fund has other tax problems after the 7 years. At that point,the distributions total to the full $50,000 you invested, so you have received all of your capital back. Then 100% of the distribution is taxable as a capital gain. In addition, when you sell, your cost base is zero, so 100% of the proceeds of selling are a capital gain.

    The fund you are mentioning also clearly has a non-sustainable distribution. If we assume it makes an average return of 7-8% but pays out $600/month, after 7 years, the $50,000 will be down to about $20,000. By year 10, it reaches zero.

    If you sell after year 7, the $20,000 left in the fund is all a capital gain, since your cost base is zero.

    There is a common misconception that a ROC distribution is “tax-free”. It is at best a tax deferral. The other popular misconception is that it is somehow related to the profit of the fund. The distribution is an arbitrary amount of your own money given back to you.

    My advice would be to avoid the ROC funds with leverage unless the entire distribution is paid onto the loan. Also, I would avoid completely any fund with such a ridiculous unsustainably high distribution. There is no way this fund can be expected to actually make a 14%/year return to keep up with the distribution.

    Ed

  25. 28. AMeer

    Thank you David and Ed.
    your advise help me taking the decision

  26. 29. Investor X

    Can someone please clarify the following “allowable” treatments for distributions to keep investment loans tax deductible?:

    Regular dividends> pay down mortgage
    Dividends including capital gains>pay down mortgage
    Return of capital>pay down HELOC

    A good dividend-paying fund could pay down your mortage faster than the plain-jane smith manoeuvre as long you don’t get too much ROC.

    For example, if you get $4,000 in dividends (excluding ROC) and pay $4,000 in interest on an investment loan, there would be a relatively small tax benefit (between the taxation of dividends and interest expensed) but then you can put $4,000 on your mortgage rather than putting the tax savings from the interest expensed ($4,000 x 40% = $1,600).

    My condolences to those that got into the market last year but this year looks like a good time to test the water with the Smith Manoeuvre.

  27. 30. Ed Rempel

    Hi Investor X,

    The basic rule is that taxable income distributions that are paid out don’t affect tax deductibility, but any non-taxable distribution reduces the deductibility. If you receive a distribution that is capital gains or dividends, you can pay this down on your mortgage and then reborrow.

    If the distribution includes return of capital, then the deductible part of your investment credit line is reduced by the amount of the distribution. If you receive a $1,000 distribution that is return of capital, then the interest on $1,000 of your investment credit line is no longer deductible.

    There are a lot of people promoting the Smith/Snyder with a ROC distribution paid down on your mortgage, but this actually reduces the benefit of the SM. Every dollar of ROC distribution paid onto your mortgage is also a dollar of your investment loan that is no longer deductible – so you have not reduced your non-deductible debt at all. All you have done is refinanced a dollar of your mortgage at a higher rate on a credit line that is also not deductible.

    This reduces the benefit of the Smith Manoeuvre and the math can become complicated. Remember it is your responsibility to prove that your interest deduction is correct. CRA’s attitude is generally to question the entire deduction and then you have to prove that is is correct and show all your calculations and all the transactions.

    Any distribution that is paid entirely down onto the investment credit line or used entirely to pay the interest on the credit line does not reduce the tax deductibility of the remaining balance of the credit line. However, this does not generally lead to productive strategies, however.

    Having the interest paid by the distribution reduces your future return. If your investment makes a higher after tax return than the credit line over time, then taking money out of the investment to pay the interest will reduce your future return. If you do the SM properly, there is usually no need to use any money from the investments to pay the loan interest.

    Paying the distributions down on the loan ends up with what we call a “race to zero” – which will reach zero first, the investment or the investment credit line??? This is a ridiculous strategy that nearly eliminates all the benefit of the SM, since the large expected benefit of the SM comes from the long term compouned return of the investments. The expected benefit from the SM over 25 years should be a number like $500,000 – not $5,000.

    You may think from this that it is good to receive taxable dividends or capital gains, since you can use these to pay down your mortgage more quickly. This is typical Canadian “Sacred Cow” thinking – instead of focussing on build wealth.

    The goal of the SM is not to pay your mortgage off quicker – it is to build wealth without using your cash flow, which helps you have that comfortable retirement you want. We have seen the finances of thousands of Canadians and I can tell you that it is usually the poor and middle class that have no mortgage and no debt. The wealthy tend to have far higher debt that they have used to build wealth and is the reason they are wealthy.

    We have run many scenarios and found that the biggest long term benefit of the Smith Manoeuvre comes from the long term compounding of investments. Having taxable distributions usually reduces the long term benefit because of the “tax bleed”.

    If your investments are 100% tax efficient and never pay a distribution, then your benefit of the Smith Manoeuvre is almost always higher than any version at all using any distributions – taxable or not.

    The one exception can be dividends received if you are in a lower tax bracket and are under 65. In this one case, dividends result in no tax, so there is no tax bleed.

    If you are in a middle or higher tax bracket, however, we would recommend to try to avoid all distributions and focus on building wealth – not on paying off your mortgage.

    Ed

  28. 31. Investor X

    Thanks for the speedy feedback Ed.

    Your logic makes sense to me in terms of the return of capital. To be on the safe side, if I got a $1,000 ROC, I would pay it against my HELOC to keep the record-keeping clean. That basically means I borrowed $1,000 to buy an investment, the investment was redeemed (without my consent) and the money returned to me so I should pay back the loan that funded the purchase. Now I have $1,000 more available credit on my HELOC to invest somewhere else.

    I know that a quick pay down of my mortgage is somewhat secondary to the whole idea of growing wealth (using the bank’s money) but I’m still a conservative person that thinks that something can go wrong. If I can knock a few years off of my mortgage – why not? If I can create an income stream in addition to my RRSP’s at retirement – why not? There are those that say that I’m crazy to invest in the stock market but I’m taking it one month at a time and seeking as much info as I can. Diversify, DCA, minimize borrowing costs and watch out for ROC’s are the main lessons that I’ve learned.

    Thanks again for the info.

  29. Ed,

    Great comment. However, note that with the SM, even if one decides to pay off their non-ded mortgage faster, they still have the deductible debt left behind.

    My strategy for the sm is not only to pay off the non ded mortgage faster, but to create cash flow via tax efficient dividends.

  30. 34. Chris

    I’ve got a quick question about capital gains. Today I sold some shares in an investment account that is being funded by my HELOC. The cost of these shares was $4477.56. My net proceeds were $5598.98, representing a capital gain of $1121.42. So here’s my question – if I withdraw the $1121.42 (i.e. the capital gain) and re-invest the $4477.56 (i.e the original cost of these shares), does that impact the “deductability” of the interest incurred by my HELOC?

    I know that the easiest solution would be to confirm with a tax accountant, and I know that the smartest thing to do would probably be to apply the $1121.42 to my mortgage, and then withdraw another $1121.42 from my HELOC and invest it, but I’m just curious to know what the ramifications are should I choose do something else with the capital gains.

    Thanks!

  31. Chris, from reading Tim Cestnick’s book, it appears that if you withdraw the $1121.42 from your investment account, it will reduce your heloc deductible portion by that amount. So if you had a heloc of $10k invested, and you withdraw the 1121.42, you have reduced your tax deductibility by 1121.42/10k = 11%.

    As you mentioned, you will need to double check that with an accountant as I may have interpreted Mr. Cestnick’s examples incorrectly. If you do confirm with an accountant, it would be great if you would report back.

  32. 36. Lou

    Quick question for you – Does income received from US or Global investments satisfy CCRA’s interest deductibility requirements?

  33. Lou, as far as I understand, you can hold foreign equities under an investment loan.

  34. 38. Ed Rempel

    Lou,

    They are fine. Income is not required for deductibility of an investment loan. A muutal fund or stock that has never paid a distribution and is not specifically prevented in their prospectus from ever paying a dividend is find, based on IT-533. All that is required is a reasonable assumption that it could pay out income some day.

    Income on foreign investments is taxable to residents of Canada, as well.

    Ed

  35. 39. Cannon_fodder

    Ok, here’s a question: what if you implement the SM but you don’t actually pay the interest? This is possible if you already have a significant untapped HELOC amount. You just let the interest accumulate (and interest on the interest accumulate). If you don’t actually make any payments, can you still claim the deduction?

  36. Cannon, capitalizing the interest is tax deductible. Canadian tax rules state that you can use borrowed money to service an investment/business loan and have interest from both tax deductible. That is how I have my leveraged loan set up.

  37. 41. Cannon_fodder

    Do these scenarios meet the CRA test for deductability?

    Say you’ve transferred money from your HELOC to your investment account and, because you haven’t found enough suitable investments, the money is sitting accumulating interest. The interest would not be more than the loan interest.

    In another scenario, what if I invested in the Beta Pro TSX Bear ETF. After all, I’m waiting for another pullback before investing into financials, energy, etc. and that would pull the entire TSX down. The ETF, as far as I know, does not pay any dividends at all. Would it be questioned by the CRA?

    The above scenarios are only temporary I imagine but every little bit helps….

  38. CF, according to some accountants that i’ve spoken with, providing that the money isn’t sitting in your investment account for “too long” then it should be ok. As for how long is “too long” is anyones guess.

    Technically, the betapro ETF’s should not qualify for tax deductibility, however, my accountant has told me most of his clients do not invest for income who carry investment loans. They simply invest.

    Again, you should get a second opinion from an accountant just to be sure. When you do, report back here!

  39. 43. Ed Rempel

    Hi CF & FT,

    FT is right about the investment account interest. Holding cash temporarily within a portfolio is no problem, but holding a cash investment long term where you have no chance to make as much as the loan interest rate would be a problem. “Too long” is not a few months – it would be an unreasonably long time to be considered a temporary cash holding.

    Your cash holding sounds perfectly fine, Cannon.

    As for the Beat ETF, the critical test is any investment that COULD pay income. Whether it actually ever pays income is irrelevant – as long as it COULD pay income. In IT-533, CRA specifically mentions investing for the purpose of earning income and then goes on with an example of an investment where the prospectus specifically forbids paying income.

    Income is irrelevant. Only whether it COULD pay income is relevant.

    The Bear ETF is technically not allowed, since it is impossible for it to pay income.

    However, again if it is a short term holding within an overall portfolio, it should not be a problem.

    In general, don’t get too caught up in which investments are allowed and which are not. Almost anything would be fine short term and most invesments COULD pay income long term. Just focus on choosing investments based on their risk/return profile and their long term growth potential.

    Ed

  40. 44. vaggo

    Ed,
    What about residents of Quebec? Aren’t the tax rules slightly different when it comes tax deductibilty when borrowing to invest? Thanks for looking.

  41. 45. Ed Rempel

    Hi Vaggo

    Yes, rules are a bit different in Quebec. The main difference is that you can’t actually get a refund. The interest is deductible, but only to the extent that you have taxable investment income. You can carry the interest forward to a future year.

    The SM is still generally a good strategy long term, even without the tax refunds. If you invest tax efficiently, you can keep carrying forward the interest deduction and essentially offset taxable investment income for a very long time – possibly forever.

    Ed

  42. 46. Lynn Kadidi

    Great site, excellent discussions. Got a line of credit form PC Financial ($110,00 @6.25% for 5yrs) which is tied to my house…house mortgage is paid off. I am new to investment. I am not sure what to do, thinking of putting money in a 5% savings account. Would interest deduction off set the difference between interest paid and interest received?

  43. 47. DAvid

    Lynn,
    Most Secured Lines of Credit are available at prime (currently 4.75%), so unless you expect a great increase in interest rates, locking in at 6.25% seems expensive.

    You will pay taxes on the interest you earn in the savings account at your marginal tax rate, so no, the tax deduction on your borrowing interest will not generate a profit.

    DAivd

  44. 48. smcmanus

    Please help. I fully do not understand REIT’s. There is a company I have been looking at purchasing with an investment loan called Extendicare. It is listed on the Toronto Stock Exchange. I think it is considered a REIT. On there website it says the following:

    http://www.extendicare.com/investors/unit_dist_income_tax.aspx

    “Management estimates that approximately 70% of the 2008 distributions of Extendicare REIT and Extendicare Limited Partnership will be characterized as tax deferred returns of capital for Canadian residents. The remaining 30% of distributions of Extendicare REIT paid in 2008 are expected to be taxed as dividends and those paid to Canadian residents are eligible dividends as per the Income Tax Act (Canada) (the “Act”). To the extent a portion of the remaining 30% of distributions of Extendicare Limited Partnership allocated in 2008 is taxed as dividends, those paid to Canadian residents are eligible dividends as per the Act.”

    Company make’s monthly distributions of $0.0925/month ($1.11/year). Current price is $5.50. If I were to purchase 10,000 shares with an investment loan at 6%. How would this work out for me as far as taxes that I will have to pay on the distributions ? I live in Ontario and make $100,000 year. Would this company qualify for an investment loan? I get confused with the 70% tax deferred and the 30% is dividends. Will the new Income Trust laws in 2011 effect this company. Appreciate your response.

  45. smcmanus, what they mean here is that 70% of the distribution will be return of capital and 30% will be considered dividend. The 70% will reduce your adjusted cost base (ie. no tax until you sell), and the 30% will be taxed as a a dividend. If you want to see how much tax you’ll pay, go to taxtips.ca and run the calculator.

    You can theoretically buy this stock with an investment loan providing that you don’t withdraw the ROC portion of the distribution. However, to keep things simple, I never hold any stock/income trust that has ROC.

    The new income trust rules coming do not affect REITs.

  46. 50. smcmanus

    Thanks for you quick response FrugalTrader. Another question. You say not to withdraw from the ROC portion. Where does it go. Basically are you saying I have to take that monthly ROC payment and pay down my investment loan or does it just go toward my principle then spend the dividend portion on the anything such as monthly interest?

    There is an option to reinvest the distributions into more shares. How will this effect my ROC?

  47. smc, as I’m not a tax advisor, I cannot tell you for sure. However, from speaking with various accountants, it appears that provided that you keep the ROC within the investment account (reinvest it or whatever), the investment loan should be fine. For me however, since I plan to withdraw my dividends to pay down my non ded mortgage, having ROC would simply be an accounting mess.

  48. 52. Ed Rempel

    Hi SMC,

    FT is right – the ROC is an accounting nightmare. You need to be able to track that every dollar of ROC was either paid onto the investment loan, or reinvested. If you can’t prove it to a CRA auditor, then you have to do a calculation based on the book value (declining because of the ROC) to figure out how much of the investment loan interest is still deductible.

    In addition, if you believe in leverage and are confident in your investment, why would you want to with draw your principal (the ROC is getting principal back) in order to pay down the loan?

    It is also a risky strategy to leverage into only one company or sector, especialy if you are relying on the distribution from the investment to pay the investment loan interest. One bear market like we are in can destroy this type of strategy.

    It is best to have the distribution reinvested. That is generally the most effecitve and lowest risk strategy. The other option is to pay the entire distribution into a separate bank account that is used only to pay the interest on the investment loan and/or invest.

    Ed

  49. 53. Investor X

    My opinion on the ROC is this:
    1. If you know at the time of distribution what portion of the distribution is ROC (as opposed to dividends) you should reinvest the ROC portion in that stock if you have faith in it or pay down your HELOC if you have cold feet.

    2. If you DON’T know how much of a distribution is ROC then it might be better to temporarily pay down your line of credit and when you get your T5′s you will know how much is dividends (available for withdrawal if you want to use the cash) and how much (ROC) must stay within the “investment circle” – HELOCS and the investments themselves.

    I can see how messy the ROC issue is and how it would be easy to make a mistake when it comes to the tax deductibility of HELOC’s affected by them.

  50. 54. LB

    So here’s something interesting (at least to me :) ). With the swing in the markets I’m in a situation where my portfolio is up due to dividends but I have an unrealized capital loss.

    To keep the math simple, let’s say that I started with $10k loan that was fully invested. Over the last five years the cost basis for my portfolio has gone up to $15k because of reinvested dividends. The market value of my portfolio is now worth $12,500.

    Now the fun part.

    I first want to realize the capital loss by selling my entire portfolio. Next, I would like to remove the maximum amount from my portfolio before I re-invest but would still like to keep the total interest from my loan tax deductible.

    From what I have read, and what was stated in this posting, is that I should be able to remove $5k (the re-invested dividends) and only need to re-invest a total of $7,500 to keep the total interest on my $10k loan tax deductible.

    Did I get it right?

    Thanks,
    LB

  51. 55. nobleea

    LB;

    I think that is correct in theory, but in practice, you may be only allowed to sell 5K (the reinvested dividends), get the capital loss on the 5K and keep the rest invested. I’m not sure.

  52. 56. nobleea

    Alright, here’s a challenging question for those in the know.

    My soon to be wife is a new teacher. There is an option with her pension plan to buy years of service, up to 10 years. This would allow an early retirement for her with full pension.

    My question is, if I took out a loan to buy the years of service with the pension, would that loan be considered an investment loan and thusly, be tax-deductible? My first guess is no, but there are some weird addendums in the tax system about pensions, so maybe it would be.

  53. 57. discfree

    Just following this thread and I’m a bit confused now and disturbed about what an ROC fund is and and what an Income trust is…..Let’s take Enbridge Income Fund for example or even RioCan REIT or Bell Aliant Regional trust? Are these Income trusts which gives most of it’s earnings back to the investor or an ROC fund which returns the capital you invested in it? I thought all distributions paid by income trusts were deemed as dividends and that they’d be a great vehicle to apply the the SM as they generally pay better yields than “normal” stocks do. But if it’s too tricky/convoluted to get a tax deduction on the interest paid to purchase income trusts to implement the SM, then what good is the SM unless you’re lucky enough to pick up solid blue-chips yielding 7-8% for example? Could someone please clarify? Thanks very much…

  54. discfree, yes it’s true, most income trusts pay a portion of their distribution as ROC.

    As for dividend stocks, you don’t need 7-8% dividends right away, the key is to pick strong dividend stocks that have a history of increasing their dividends over time. Remember that the SM is a long term investment strategy, not a quick arbitrage scheme (although it could be at todays rates).

  55. 59. discfree

    thanks FrugalTrader…did some more research on your site and it makes more sense now….purchasing the income trusts outright is fine, but using them in the SM would be an accounting mess…and yes, at today’s depressed prices, I think such yields are more of a possibility……..thanks for having this site btw, learning a lot and saving a lot (headaches too)

  56. 60. discfree

    I have another question (if I may) regarding this topic (if it should be a part of another thread, please let me know).
    I have read one of Derek Foster’s books which outlines selling put options to buy quality dividend paying companies. Let’s say as an extreme example, I use the SM, set up an account and I end up selling put options all year round and collect premiums and by year end I haven’t managed to purchase any stocks because the put option (on the buyer side) has expired worthless. All money made in my account is by collecting option premiums only. So my question is, is the interest on the loan I received still tax deductible (I have earned income from my loan after all and it isn’t a ROC) and how would the premiums be taxed?

    Thanks very much

  57. 61. Ray

    Very interesting discussion.

    I have a questions related to this. A family member of mine has a mortgage which is split between a covenational mortgage and a HELOC at Prime. They do not use the HELOC and they have allowed me to use it. I want to use a portion of this HELOC to buy some conservative unregistered investments. My question is can I claim the interest on the HELOC direclty on my tax return (i.e. at the Prime Rate the bank is charging), or does it have to be structured as a loan from my family member at some interest rate (which they would claim as income, and I would claim as a deduction)?

    I guess what I’m asking is is it possiblle to skip the step of the loan arrangement between the family members?? Maybe if there is some other agreement that states I’m responsible for what I borrow under the HELOC directly??

    Thanks

  58. 62. smcmanus

    My Mortgage is up for renewal May 1, 2009. I currently have $150,000 outstanding. My house is assessed for $300,000. I want to refinance and pull 100,000 of equity out of my home to invest. So now my new mortgage will be $250,000 ( 150,000 + 100,000). The big question is the $100,000 that I pay interest on Tax Deductible if I invest into dividend paying stocks? If so how do I show it to revenue Canada?

  59. smcmanus, check out this post:
    http://www.milliondollarjourney.com/the-smith-manoeuvre-a-wealth-strategy-part-1.htm

    As well, stay tuned for tomorrows post on how to claim the deductions on your tax return.

  60. 64. MikeM

    Is there a way to stay in a tax-deductible position in this situation?

    I used my HELOC for an investment in dividend-generating funds. I am now planning on selling my house. I am planning on keeping my mortgage with the same institution and setting up another HELOC on the new house. However, given the uncertain real estate market these days, I am not planning on purchasing the new house until my current one sells, therefore there could be some lag between the old mortgage and the new one.

    I could just pay down the investment loan from the proceeds of the house, but that defeats the leverage I was trying to create.

    Is there a way I can juggle the amount on my current HELOC so I can maintain traceability and deductibility as an investment loan?

  61. 65. cannon_fodder

    MikeM,

    Is it possible for you to use another LOC to payout the HELOC? I’d imagine the interest rate would not be favourable at all compared to the HELOC but for the temporary difference between selling/buying it may not be unpalatable.

    As long as that LOC is only used for maintaining the leverage I’d imagine you would have little problem convincing CRA of its applicability.

  62. 66. Jatinder

    Is it true FT, that we should not be buying RioCan with HELOC for SM, as CRA could decline interest deductibility?

    (I got some RIOCAN lately and want to be sure before its too late, but not much)

    Thanks!

  63. Jatinder,

    The problem lies when you withdraw distributions. If you withdraw a ROC and spend it, it will reduce the tax ded of your investment loan. A way around this is to keep track of the amount of ROC, and either a) keep it in the investment account or b) withdraw the distribution and pay down the HELOC by the amount of ROC. Needless to say, the accounting can get extremely messy when you have ROC with an investment loan. However, double check with an accountant, they may have a better strategy that what I suggested.

  64. 68. Jatinder

    Thanks FT!

    Would investing in index funds be ok too?

  65. Jatinder, it depends on the index that you are covering. If the index covers the income trust index, like XTR, then i will have a ROC portion of the distribution, which again could me an accounting mess. But generally yes, index funds would qualify to be invested under an investment loan.

  66. 70. Jatinder

    FT, I was thinking about TD e-series funds. Any problems with that?

  67. The TD e-series “should” qualify for investments under an investment loan. Note though that foreign dividends are taxed like interest

  68. 72. Tom

    Hi everyone,
    I’d like to start off a leveraged portfolio with $5K and was thinking of buying the iShares CDN Dividend Index Fund (XDV) as I like the preferential tax treatment of the dividends. I plan on reinvesting all dividends for at least the first 20 years.

    My question is on the iShares website under the distribution detail it shows the eligible dividends but it also shows a return of capital amount. Would this affect the tax deductibility of my investment loan?

    http://ca.ishares.com/product_info/fund_history.do?ticker=XDV&year=2008

    Thanks!
    Tom

  69. Hey Tom, the tax deductibility of the loan could be compromised if you withdraw the distribution. I’ve heard from some accountants (not verified) that as long as you keep the ROC within the investment account, you “should” be ok. You might want to double check that.

    Alternatively, you could withdraw the ROC and paydown the investment loan, then reborrow again. Another downside of receiving ROC within a non-reg account is that you need to track the adjusted cost base after EVERY distribution. This adds to the PITA factor.

  70. 74. Tom

    Thanks FT!

  71. 75. Ed Rempel

    Hi Tom,

    FT is correct. CRA is concerned about the “current use” of the money borrowed to invest. If you receive any ROC payments, your loan is still deductible as long as you reinvest the entire amount directly and can trace it – or if you pay the entire amount down on the investment loan (and can trace it).

    Ed

  72. 76. Brendan

    So how exactly do you get your money out of your non registered account when retired, if you are using mutual funds with the SM?

    If I DCA over 15 years, when I sell I am (hopefully) taking some capital gains. Will this not reduce the deductibility of the loan? Or do i “pay back” the original value first and then only take out the gain? i.e I purchased 100 dollars of funds that are now worth 200. So, I have to pay down the loan by 100 and pocket the 100 gain? Or do I leave the original 100 in the account and take out the gain?

    Not sure if I make sense but it seems like an accounting nightmare when you retire.

    Wouldnt it be easier to simply hold dividend paying stock, and never sell? Just withdraw the dividends?

    In FT’s example of the 10k loan growing to 15k means taking out 5k will screw 1/3 of your loan up.

    Isnt this what will happen to a mutual fund account in a SM?

    Most cash flow from a fund is from selling units not dividends.

  73. 77. cannon_fodder

    Brendan,

    I don’t hold mutual funds in a non-registered account but if I’m not mistaken, they still classify distributions as interest, dividend, capital gain or ROC. So, in essence, you could build a similar, income producing portfolio using mutual funds or their ETF counterparts.

    Even if you hold dividend paying stocks, wouldn’t you reinvest the dividends in more stock? That would change your ACB if you did.

    Frankly, if you find it too difficult to keep track of your investments, then perhaps you shouldn’t be contemplating the SM until you are. I’m aware that there are free spreadsheets out there that will help.

  74. 78. Brendan

    Cannon, I have no problems keeping track of my investments.

    I do however sometimes have trouble saying or typing what is inside my head, or at least i come across the wrong way.

    My concern is how mutual funds effect the deductibility of the investment loan.

    In my dad’s RSP he has a nest egg and withdraws 1k per month to suit his needs. 1 K worth of funds are sold and put into his bank. CRA collects tax as all RSP withdrawls are taxed the same regardless of source.

    But if I were to DCA over several years and now want to retire I am confused to how mutual funds work with an investment loan.

    For example lets say that my ACB over time is 50 dollars per fund unit. Now when I take money out lets say the units are 100 dollars.

    If I need 1k income per month I sell 1K of units, BUT since 500 is capital gain then the other half is my original investment, so my loan would lose 500 dollars of deductibility per month.

    To me this is the same as a ROC fund is it not?

    Ed Rempel says to not use ROC funds but I dont see how you can take your money out of your non reg account without taking back some of your capital.

    I know mutual funds have dividends and interest but most of that is eaten up by the MER. Or at least that is how I understand mutual funds.

    FT uses the Tim Cestnick example of taking 5 K out of your account, which reduces the 10K loan by 1/3.

    Isn’t this the same scenario with mutual funds?

    Hopefully I have made myself more clear, and someone can point out where I am wrong, if in fact I am wrong.

  75. 79. cannon_fodder

    Brendan,

    First let me apologize if my comment seemed rude. I have seen too many people on sites like this contemplating strategies that are too advanced for them – they get caught up in the hype and sometimes that is due to overeager ‘helpers’ believing that everyone should think like they do.

    I don’t really see a difference with your situation because it is mutual funds, so your question is really a very good one. I know of mutual funds that have yields very much similar to a bank stock – around 4% or so and that is certainly not eaten up by the MER.

    So, regardless of whether it is mutual funds or stocks themselves, I think just such a scenario (“Ok, now I’m retired. What do I do with this SM/HELOC now?!”) merits its own entry.

    Perhaps Ed Rempel could be coerced to offer up how he deals with this situation for various client types.

    I hadn’t thought too much of it because I’m not likely to keep the investment loan intact. It comes down to a loss of flexibility in that, regardless of inflation or not being the “best” use of my money, you do lose about of flexibility when you have a HELOC that would be hundreds of thousands of dollars.

    Plus, I’ve built an SM portfolio that has a dividend yield in excess of my carrying costs (both before and especially after taxes). When my wife and I “retire”, we may end up moving to BC and their very preferential treatment of dividend income will be an additional boost. My hope is that we will have enough capital built up that it will provide a dividend income stream that will not require us to touch the capital, and thus the HELOC question is moot.

    Perhaps the downside to the ROC discussion is that you don’t control the distribution amounts or schedule – the mutual fund company does. Whereas, an SM portfolio invested in equities that don’t have an ROC portion allow you to strategically and surgically sell investments, that will lessen the deductable portion, as you deem necessary.

    I wouldn’t be surprised if there are exponents of the SM that say, “Don’t worry. With all of that growth in your house value, you can quickly replace whatever is lost by borrowing even MORE from your house and add handsomely to your investments while realising an even bigger tax writeoff.”

    Good question – I honestly hadn’t thought that much about this inevitability.

  76. 80. Brendan

    Cannon, I did not find your comment rude. No worries.

    While I understand the mechanics of the SM perfectly, I admit my knowledge of mutual funds is limited. I always thought of them as stocks per say that dont pay any dividends (they become MER food).
    The objective of funds is to buy them and hope they go up when you have to re sell them.

    I have a strong bias towards dividend growth stocks and my initial plan was to purchase such stocks via the SM through my DRIP accounts.

    Most reading I have done on managed funds isnt too positive. While there are good managers, finding them before they “do good” is the hard part.
    I guess you can say the same for stocks as well. Just because a company has done well for decades (think GE cutting the dividend after decades of raising them ) is no guarantee they will do so in the future.

    While there are no guarantees there certainly are reasonable assurances.
    Will BMO always pay a dividend? Not 100% for sure, BUT the fact that they have been paying them for longer than Canada has been a country leaves me assured they will continue to do so.

    Same goes with a managed fund. I am thinking of the Templeton growth fund for example. It has a very long excellent track record, and I would believe that it would continue to do so so long as the same manager/management style is intact.

    I think the key is to stick with it for the long term. Actually after reading the Dick Davis Dividend the premise of the book is that everything works, but not everything works all the time, meaning that dont jump on the growth bandwagon when CNBC is happy, and then switch to value when CNBC is sad.

    Be it index funds, managed funds, growth stocks, value stocks, dividend growth stocks, just pick a style and stick with it.

    ANy how after reading about index funds I think they would be a good way to implement the Sm. This is where I got thinking what do you do when you retire?

    How do you pull your money out of the financed account and maintain deductibility?

    I agree there is not too much said about this. Sure with dividend growth stocks it is simple. Buy the stock, dont sell and withdraw your dividends each month as you need them.

    Mutual funds withdrawn as a pure capital gain would be the same as a ROC (half of the withdrawal anyway) according to FT’s article on keeping your loan deductible.

    I am sure I am screwing things up in my head anyway.

    I would also encourage Ed to help us understand this issue better.

    Cannon have you met Ed in person? I met Ed and his wife Anne this summer in Winnipeg. Very nice people.

    I got a very good “vibe” from both of them and liked the fact that i did not get a typical cookie cutter “financial plan” that you seem to get with most CFP’s.

    Up until I met them I didnt see myself considering managed funds, but after our meeting I can see myself working with them for the long term.

    Anyhow I am going off the rails here. Maybe others can chime in about winding down or harvesting your SM with mutual funds as your investment?

  77. 81. cannon_fodder

    Brendan,

    Yes, I did have the pleasure of meeting Ed. In fact, I’ve been a customer of his (he helped me arrange a very good rate on my BMO Readiline mortgage at no cost to me) and he purchased a customized, Excel-based SM calculator from me.

    I know Ed is quite busy as he seems to come by here infrequently but then pepper the site with responses to many questions.

    If this is not the best source for information about the SM, both in theory and practice, then I don’t know what is. An article on the drawdown phase of a leveraged portfolio would fill in a critical gap in the discussion.

  78. Guys, I’ve written a post similar to what was discussed, that is, what to do with the investment loan once the mortgage is paid off. I will look into the investment/HELOC draw down phase during retirement.

  79. 83. Brendan

    FT I look forward to the draw down article.

    I just cant seem to wrap my head around selling mutual funds for a capital gain without incurring a ROC.

  80. Brendan, selling mutual funds with a capital gain is different than receiving a ROC distribution. If you sell a fund for profit, then providing that you plan to re invest that money, the investment loan should remain deductible. Note that you will have to pay tax on the capital gains though.

  81. 85. Brendan

    FT in this article you use the example of pulling 5K out of your loan to go on a holiday. Original loan is 10K with a 5K capital gain. You said now only 2/3 of your loan remains deductible, even though the original 1oK is still “in there”.

    Retirement situation would be the same.

    Maybe that is how the draw down works? Sell your fund units, pocket the capital gain and reinvest the balance?

  82. 86. Brendan

    P.S.

    Sure if you reinvest ALL the money from the fund sale the loan remains deductible, but at some point you will want to draw money to live off of.

    I guess I am wondering how do you do that and keep the investment loan “intact”, as the puure SM wants you do keep the loan forever.

  83. Brendan, that is a great point, and you are right, if you spend the capital gains, the investment loan will be affected. Let me get some clarification and get a post together.

  84. 88. Brendan

    Ed talks about the Smith/Snyder being used for retirees needing income, BUT he also seems to be very strongly against it at the same time.

    Maybe you build up with the Sm and then convert to the Smith/Snyder?

    Hope not.

    FT take your time on the post. I have about 15 years till I retire!

  85. 89. cannon_fodder

    FT,

    Thanks for jumping in and pointing out the March 3, 2009 article. Sometimes we think so much alike it is scary!

  86. 90. Ed Rempel

    Hi Brendan, Cannon and FT,

    The optimal strategy for withdrawing money during retirement after doing the SM varies a lot depending on the situation. If you recall from the article on clawbacks for seniors, the effective marginal tax rates for retirees varies between 21-71%. This tax bracket makes a huge difference in the strategy that will work best.

    In short, this part needs to be done custom for each client.

    There are a few options with mutual funds:
    1. Systematic withdrawal plan – This produces capital gains, depending on how much the portfolio has grown.
    2. Smith/Snyder – This produces ROC for 8-12 years and then capital gains.
    3. Dividends

    A couple of points that will address most of your concern, Brendan:

    1. Capital gains withdrawn from a fund leave the investment loan interest tax deductible generally, although you need to be careful of the tracking. So, if you withdraw $10,000 and $5,000 is a capital gain, then your the other $5,000 is your principal. The amount of the loan that remains deductible is reduced by the amount of principal withdrawn. The capital gain portion is fine.
    2. The amount withdrawn to pay the loan interest maintains the tax deductibility.

    For example, let’s say you borrowed $100,000 at 4%, it grew to $200,000, and then you started withdrawing $10,000/year after you retire. Of this $10,000 of income, $5,000 would be a capital gain and $4,000 can be used to pay the interest on the investment loan. Therefore, only $1,000 of the loan becomes non-deductible.

    Many options in retirement require tracking of how much of the loan remains deductible. The Smith/Snyder does have have the side effect of losing the tax deductibility of your loan, but it can be sometimes be the most effective, for the highest tax brackets in the short term, especially for those low-income seniors in a 71% tax bracket (affected by the GIS clawback and income tax).

    Dividend strategies work for low income seniors, but usually not for those affected by any of the various clawbacks.

    We do have another cool strategy that will probably be in an article soon.

    Ed

  87. 91. Brendan

    Thanks for jumping in Ed.

    So Tim Cestnick was wrong then? I was under the assumption that any taxable with-drawls , dividends, interest, AND capital gains does not effect deductibility. This appears to be the case.

    But, since the SM goal is to keep the loan “forever”, and you have invested for capital gains then really you have to keep half of your gains inside your portfolio to remain deductible.

    Does this not cut your return in half then?

    I suppose you could use the principle to pay the interest, keeping the loan deductible. Your return would still be cut in half, BUT now you dont have to use your cashflow to service the loan, giving back your 50% “loss”.

    By the way where does CRA stipulate you can use principle to service a loan to keep it deductible?

    Personally I think if you do a pure SM and DCA via mutual funds it seems almost like an accounting nightmare. (I recall you do tax returns for long term clients? he he !)

    I would think the Rempel Maximum would make for a much easier accounting of with-drawls.

    Ed, I dont want to come across as doubting any of your strategies.
    I certainly do not. I enjoyed meeting you, and Anne, and look forward to a long term partnership.

    But at the end of the day cash in the bank every 2 weeks is the name of the game be it SM, TFSA , RSP, or what have you, and I am just trying to wrap my head around the SM harvest time.

    I am always reading and learning. I dont need to know how to tear apart an engine, but it is nice to know how it works. Same with my money. I dont just want to earn it, invest it, and spend it. I find having a pretty good working knowledge of it helps me appreciate it more.

    Much is said about the SM mechanics, and building the wealth, rates of return etc. Fraser even has a nice software calculator.
    Not much is said how to reap the rewards.

    I can’t wait until the new cool strategy is revealed.

    Any hints?

  88. 92. Brendan

    So here is a possible strategy to draw down the SM:

    Figure out your interest costs i.e 100K @ 4% =4K or 333.33 per month.

    Double that number to 666.66. This is how much you draw each month. Pay your capital gains tax, and pay 333.33 to the interest, keeping your loan intact.

    Mind you this assumes a 100% capital gain, and the use of the Rempel maximum for 100K at the start.

    If you were to do this as a
    “pure” SM, aka DCA over time then it is a different ball game.

    Would a more simple strategy be to just buy 100 shares of a quality Canadian company with borrowed funds, and collect the rising dividends year after year, applying them to the mortgage pre payment?

    You could build up your borrowing room over a few months and by a different company a couple of times a year.

    After the mortgage is paid off simply collect the dividends and spend as desired.

    No complicated accounting. Simplt interest deduction each year, and a T5 slip.

    Want to sell those 100 shares? Sell em, and pay down the loan by your ACB.

    Stock markets dont scare me, and neither does the gradual shifting of the original non deductible leverage to a deductible leverage.

    The accounting nightmare does though.

    I like simple.

  89. 94. Kate

    Ed, just wondering if you have any updates to a couple of Brendan’s comments in post 91 – specifically “where does CRA stipulate you can use principle to service a loan to keep it deductible?” and “I can’t wait until the new cool strategy is revealed”.

    Would like to hear about both, cheers.

  90. 95. Brendan

    Kate I have done a bit of digging and I still can’t find where CRA says you can deduct compound interest.
    Everyone refers to bulletin IT 533. This bulletin states you can deduct compound interest on a cash basis pursuant to paragraph 20(1)(d).

    I cannot find this information. Trying to navigate the actual tax act is difficult.

    I did however come across this:
    http://www.ctf.ca/articles/news.asp?article_ID=1907

    The way I read it is that you CANNOT deduct compound interest. If you borrow to pay loan interest then you are not borrowing to earn income you are borrowing to service interest.
    In the provided link company x repays the interest and then immediately re borrows it again to earn income. This is simple interest.

    As much as I would like the SM to work i am starting to smell a bad fish. Too good to be true. Borrow money, never pay out of pocket to service your loan, and reap the rewards. Does this sound like something CRA will let you do?

    I am awaiting confirmation from CRA (I sent in a letter for a tax opinion on this) before I commit. I also have an accountant who specializes in tax law to give me an opinion on this as well.
    Mr Fraser should have asked for and paid for an advanced ruling on the SM if he believes this really works.

    Personally as it stands now i believe deducting compound interest on an investment loan is a grey area, that people are getting away with at this point because:
    1. there are not many people doing this, and the amounts are so small it is not worth “going after”.

    2. CRA simply has not gone after this strategy at this point yet. CRA will initiate different “projects” i.e people in the service industry who receive cash tips, contractors the next few years, and buy low/donate high schemes.

    I still think leverage can be usefull but if I initiate a leverage strategy i will simply deduct the simple interest and pay it out of pocket.

    I know I can contribute to an RSP and I will never worry about it being scrutinized.
    I am not as confident with deducting compound interest.

    In theory it all sounds good, but I would hate to do this for 5 years and then be reassesed by CRA..

    Does not pass the smell test.

    By the way if anyone can post the actual tax law, specifically 20(1)(c), and 20(1)(d) this would be helpful. IT 533 alone does not give the whole story.

  91. 96. Kate

    Hi Brendan,

    Thanks for the digging. I am aware of the tax bulletin and find that it is quite clear on loan interest being deductible for investments – I have no issue there, it was more around the ROC distribution that then reduces the portion of the loan which qualifies for deductible interest.

    In the preceding discussions there are different views offered. On one hand, it is stated that returns of capital would reduce the portion of the loan that is eligible for deduction, but on the other hand, it is also noted that it would not have a negative impact if the amounts were directly reinvested or used to pay off the loan.

    I would just like to know, although it is not advised here due to complicated accounting, if (as long as you have everything carefully tracked in separate accounts) reinvesting the ROC via down payments on the re-advanceable mortgage (which is then used directly for investment) still allows interest on the full loan amount to be eligible for tax deduction.

    I am assuming yes, but wanted to see if there was anything in writing from CRA – but having thought about it, I don’t suppose there would be because we are just simply saying that ROC reduces the capital portion of the investment, therefore you no longer have matched the loan figure you borrowed with the investment figure dollar for dollar (equivalent of a withdrawal form the investments).

    Assuming what I have said above is correct, what then after TSM? The only way to maintain the 100% deductible portion of the loan would be to either use the ROC to pay down the loan, or reinvest directly back into the funds (or a combination of both). Maybe I’ve answered myself here. If not, someone set me right!

    Thanks

  92. 97. Ed Rempel

    Hi Brendan,

    Your concern based on the article is on the definition of “compound interest”. You are thinking of compound interest as I do – interest on the interest. In the article and in IT-533, they refer to compound interest as interest that is accrued but not paid.

    For example, your mortgage statement will show the interest paid and may also show the accrued interest up to the end of the month that is part of next month’s payment.

    The article is referring to this accrued interest that is not paid, not to compound interest as you and I define it.

    IT-533 has a similar reference, but clearly states that compound interest (interest on interest) is deductible, as long as it is paid. If you capitalize (compound) the interest on your credit line, your statement will show that you were charged interest and paid it.

    If you read IT-533, you will see that it is clear.

    You seem surprised that compound interest is deductible, Brendan. Companies do this all the time. They increase their credit lines or loans with money used to pay expenses, including other interest. There is never any doubt that compound interest in a company is deductible. The same principle applies to individuals compounding interest.

    Your concern about tax is why we do tax returns for no charge for our clients that are working 100% with us and following their plan. If they are audited, we handle it with CRA. As long as we can track all transactions properly, it is not an issue.

    Ed

  93. 98. Ed Rempel

    Hi Kate,

    It sounds like you have answered your own question – I think.

    What do you mean “pay it down on the readvanceable mortgage”? Are you referring to the mortgage or the investment credit line?

    There is not a separate rule for ROC, since it is ROC is just your principal. If your investment is not up or down, there is absolutely no difference between taking a ROC distribution of $1,000 and selling $1,000 of your investment.

    Therefore, the rules that apply to the principal when you sell also apply to ROC.

    So, if you take a $1,000 ROC distribution, $1,000 of your investment credit line is no longer deductible. However, if you paid that $1,000 onto the credit line, then your credit line is also $1,000 smaller, so it is still all deductible.

    If you do anything other than pay 100% of the distribution onto the loan or buy new investments with it, then your investment credit line becomes non-deductible by the amount of the distribution that you did not use for those 2 purposes.

    If you apply the ROC to your mortgage, that is not an acceptable use.

    Does that answer your question, Kate?

    As for the cool strategy, I have been writing a couple of other articles, but will write it soon. Stay tuned.

    Ed

  94. 99. Kate

    Thanks Ed, yes that helps, I find your explanations on this site very useful.

    I said pay down the mortgage because my set up for the investment LOC is via a re-advanceable mortgage (the mortgage principal paid is then lent back via a line of credit which is then directly used for investments). Everything is set up to be very clear and traceable so I wanted to see if using the ROC payouts to make the mortgage payment, used as a funnel for reinvesting in the funds would be acceptable or whether there would be an issue.

    K

  95. 100. Brenda

    I’m 51 and my husband is 53. We owe $100K on mortgage and have about 100K we can borrow from homeline. At our age is this still a good idea? I would like to get the mortgage paid off in 5 years.

  96. 101. Ed Rempel

    Hi Kate,

    It sounds like you have been to a Smith/Snyder presentation with the “funnel”. You are withdrawing ROC distributions to pay onto your mortgage, so that definitely reduces the deductibility of your investment loan. If you had paid the distribution directly onto the credit line, you would be fine.

    Even better is to reinvest the distributions. There is no advantage at all of paying out distributions. Paying them out leads to the “4 Meaningless Transactions”. You pay out the distribution, pay them onto your mortgage, reborrow from the credit line to invest and then you have to do the Snyder Tax Calculation to see how much of the loan interest is still deductible.

    At the end with all that effort, you are in exactly the same place that your started! The only difference is that your mortgage is a bit smaller and is replaced by an extra amount from the investment loan that is NON-deductible.

    It looks cool, because it looks like you are paying off your mortgage quickly. But you are replacing it with a NON-deductible investment loan of the same amount. Once the mortgage is gone, you have to start over again paying off your NON-deductible investment loan.

    In addition, the NON-deductible investment loan is at a higher rate than your mortgage.

    My advice – do the real Smith Manoeuvre and reinvest all distributions. We have run many simulations and it always comes out ahead of any strategy involving paying out ROC distributions.

    Ed

  97. 102. Ed Rempel

    Hi Brenda,

    Your age is not really the issue. You probably have 10 years or more until retirement and then probably 30 years after that.

    The issue is whether you have the risk tolerance and will be able to maintain the strategy through the bear markets that will happen.

    You are trying to pay your mortgage off quite fast. It looks like you believe that the SM will pay it of f very quickly. The real Smith Manoeuvre only pays it off a bit faster from paying the tax refunds onto your mortgage, although you can accelerate this with more aggressive versions. The Smith/Snyder version pays it off faster, but replaces it with a NON-deductible investment loan, so you are no further ahead.

    The reason for doing a strategy like the Smith Manoeuvre is that it creates a large nest egg for your retirement without using your cash flow (and pays off your mortgage a bit faster). It needs to be a long term strategy, because the risks decline significantly over time.

    Do you think you and your husband will be able to stick with this strategy for the long term, Brenda?

    Ed

  98. 103. Kate

    Thanks Ed – understood now, as it is the % calculation of the adjusted cost base over the amount of the loan that determines the portion of interest that is tax deductible – but if you paid the roc onto the loan directly or reinvested, it would stay at 100%. That’s great, cheers.

  99. 104. Rod

    Hi everyone,
    My employer offers an Employee Share Purchase Plan and I’m curious as to how it would work if I wanted to purchase shares through the plan using an investment loan.

    The plan works by selling employees shares of the company at 90% of the 5 day average stock price before the purchase is made. Also, they top up your purchase by 10% so if I buy $5,000 worth they would put in an additional $500 towards my share purchase. So I believe it’s a pretty good plan.

    If I wanted to borrow say, $5,000, to purchase some shares would the interest on my investment loan still be deductible? (the company regularly pays dividends).

    Thanks!

    Rod

  100. 105. Ed Rempel

    Hi Rod,

    As long as you can track that the money from the investment loan went to buy the shares and you keep the loan separate, it should be tax deductible.

    The $500 from the company would be taxable to you and is probably the same 10% that gives you the shares at 90% of the average price (is that right?), but that still sounds like a good offer.

    Whether it is a good investment is a different question. Just because you work there, you should still consider whether you would buy these shares if you did not work there. If you wouldn’t, then you probably shouldn’t buy them now.

    It is nice to own a bit of the company you work for because they send you shareholder information and you can feel like an owner, but I would recommend to keep the shares to less than 5%, or definitely 10%, of your investments.

    It is very risky to be over-exposed to one company. You already have your job there, if you also have your investments in the company and it gets into trouble, you can lose your job and investment all at once.

    Ed

  101. 106. Rod

    Thanks Ed!

    It’s actually two separate benefits…first you get to buy the shares at 90% of the average market price and on top of that the company will give you an extra 10% of your initial contribution amount. So I believe it’s a pretty good deal but I believe both benefits give rise to a taxable benefit.

    I definitely agree with you as far as not over exposing myself to just the one company. I’ve seen the documentary on Enron!

    Thanks for your help,

    Rod

  102. 107. Ed Rempel

    Hi Rod,

    It is a good idea to pay the extra 10% the company gives you onto your investment loan in order to make sure it is all tax deductible.

    Ed

  103. 108. Radek

    I got a little different arrangement in mind in regards to an investment loan, and I wonder if you could comment on the scenario below:

    With the house paid off and $100,000.00 in self directed RRSP as cash, could I take a mortgage for the investment purposes (say $100,000.00 worth of BMO stock outside the RRSP), and hold it within my RRSP?

    I believe the answer is YES!

    It looks to me that with a bank posted rate of 6%, It will generate $6,000.00 of tax deduction, which will offset about 40% of the $6,000.00 dollars paid into my RRSP – net out of my pocket: $3,600.00. + mortgage fees (lets say $1,400.00) for the total of $5,000.00
    Now lets cash that BMO dividend of 5% – this generates also $5,000.00 (less 15% for the tax)

    Overall – it cost me $750.00 (15% of $5,000.00) to get:
    - guaranteed RRSP growth of 6%
    - exposure to capital gains of the $100,000 worth BMO stock

    After one year, the same above applies, but this time there are no fixed up-front legal and insurance mortgage fees – rendering all the above profits at no cost. … and that $12,000 accumulated in the RRSP could be held in anything, subject to compounding, until the amount is big enough to justify redoing everything with much higher RRSP number.

    Where is the flaw?

  104. 109. FrugalTrader

    Radek, i’m confused by your example. When you get an investment loan or a HELOC on your house, the rate is slightly above prime (prime + 0.50%). As well, when you use investment loan proceeds to deposit into an RRSP, the loan is no longer tax deductible.

  105. 110. Radek

    Among qualifying investments in an RRSP one can opt to hold his/her own mortgage. There are some legal fees, CHMC insurance and annual bank fees for their function as a trustee. There are also strict rules in regards to the terms of the mortgage (which one contracts between him/herself and the RRSP) with the interest usually set at bank posted rate for the given term. Let’s say 1-year-open-fixed as of Feb. 2010 – that’s where the 6% is coming from in the example above.
    Now, I could be wrong, but I believe that if a mortgage like that is taken to free up money for an investment outside the RRSP, the interest paid should be tax deductible. On the other hand, it is not an RRSP contribution, but just a contractual obligation paid into RRSP based on terms defined in the mortgage. So in my opinion, I could use proceeds from the dividends outside RRSP to pay for it without losing tax deduction eligibility.

  106. 111. Ed Rempel

    Hi Radek,

    Your strategy sounds correct, but is not optimal. You are combining a good strategy with a bad one. If your home is paid off, you can just borrow against it to invest in BMO or whatever you want, and it should be tax deductible.

    We would not recommend investing all in one stock, since that would be very risky. You should be able to invest more effectively, but it should be tax deductible.

    Then you are combining that with an RRSP mortgage, which is a dreadful strategy. I don’t know why anyone would consider it. It is a combination of a horribly expensive mortgage and a very low RRSP investment return.

    In your strategy, you borrow from your RRSP at 6%. That would be a low RRSP return, especially since there are large up front and annual costs.

    Then you are borrowing at 6% to invest, when you can invest at prime +.5% today. What do you gain for paying an extra 3% on your mortgage? Absolutely nothing. You have probably the most expensive mortgage in Canada.

    Normally, you can invest your RRSP and make an equity return at say 10%/year long term. Then you can get a mortgage at 1.99% today. So you make an 8%/year profit. With an RRSP mortgage, you give up the entire 8% profit, plus you pay high fees to do it.

    An RRSP mortgage is a bad mortgage plus a bad RRSP.

    My advice – forget the RRSP mortgage. It is a dreadful concept! Borrow from the bank at 1.99% and invest it properly. You will be way ahead.

    Ed

  107. 112. Mulberry57

    What about insurance payed for the loan ? Is that deductible ?

  108. 113. cameron

    This question may have be answered but i didn’t see it explicitly being addressed – so i’ll go ahead and ask
    “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”

    1. I am confused by this, it seems like a technicality but does this mean to avoid any chance of CRA coming after you, you should invest in some dividend producing stocks, that return you greater than interest costs of the loan? I thought that as long as their is a reasonable expectation that the stocks you have invested will produce some kind of income in the future, you can invest in them for the purposes of SM. In my sitation, i have not invested in dividend paying stocks and only have capital gains, how would this impact my tax deductibility?

    2. Is it fair to say that you cannot use any of the capital gains for anything else but to pay off your deductible loan if you want to keep it tax deductible? In another thread, i was reading that any taxable gains (such as Capital Gains) can be used for anything…is this not correct – maybe i just misintereted this? Technically does this not mean that i can’t use my investment portfolio for anything else but to pay off my loans if i want to avoid nightmare reconciling accounting….

    Answers to the above would be greatly appreciated. I apologize if this has been answered before.

  109. 114. Ed Rempel

    Hi Mulberry57,

    Insurance is probably not deductible. Generally it would only be deductible if it was a requirement of the lender without which they would not lend you the money to invest. That is unlikely to be true with the Smith Manoeuvre.

    Ed

  110. 115. Ed Rempel

    Hi Cameron,

    Your situation is fine. To be deductible, your investments don’t need to produce any income, as long as you have bought them with the “purpose of earning income” (IT-533).

    Essentially, any stock market type investment is fine, because it is reasonable to expect they could/will produce income. It is also reasonable to expect that they will eventually make a profit.

    Our clients mostly earn just capital gains, as well. We avoid the “tax drag” of dividends and usually get significant tax refunds every year.

    You can also take the capital gains out to do whatever you want and still have the loan deductible. The general rule is that any taxable income can be withdrawn, but non-taxable payments like ROC will reduce the deductibility of the loan.

    The issue with capital gains is that you can only take out the actual gain, not an amount equal to the gain. You need to be able to track it.

    Ed

  111. 116. Pankaj

    Hi FT

    Here are series of questions in a situation I am descibing below:

    Say for example I take a $100k helco and invest it in India at a 7% return rate a year which is $7k.

    1. Is interest on $100k tax deductible?

    2. Will my tax deductable loan amount be $100k or $93k in the following year?

    3. What are the tax implications on ROC $7k/year?

    4. What is best? to pay the $7k towards my mortgage? or invest it in RRSP and use the big tax return to pay off my mortgage?

    Thanks everyone in advance.

  112. 117. Ed Rempel

    Hi Pankaj,

    1. Your loan is probably tax deductible, but you need to declare the investment income. If you are talking about bonds in India, then it is interest income which you must fully declare on your tax return every year. That would, unfortunately, mostly wipe out the advantage of the SM.

    If you are looking for a low risk method to invest, I would suggest not to borrow to invest at all. It is a risky strategy and only makes sense for those with general faith the markets that can stay invested long term.

    Ed

  113. 118. Ed Rempel

    Hi Pankaj,

    If you are buying bonds in India, you lose the tax benefits of tax-efficient investments, you lose the long term return of the stock market, and you are not risk free (because or currency and inflation risk).

    2. This depends on the type of investment income. If the investment income is taxable and you declare it on your return, then the interest on the $100K is all tax deductible. If the $7K is not taxable (because it is ROC or your own principal), then only the interest on $93K is tax deductible.

    3. $7K ROC is the same as withdrawing $7K of your own invested capital each year. So you get the idea, if you borrow $100K to invest, but then cash in the investments and spend the money, then obviously the loan is no longer tax deductible. The same applies to ROC. It is not investment income. It is just giving you back your original invested capital. Therefore, you must pay 100% of it onto the loan, or that amount of the loan is no longer deductible.

    4. If the $7K is ROC, the best is to reinvest it. That is better than paying it onto the investment loan or your mortgage, because the investment should make more than the loan or mortgage over time. If you put it into your mortgage, you are still invested, but your investment loan becomes non-deductible.

    The best choice will depend on your situation, but generally the best bet is to reinvest the $7K in the original investment. Taking any ROC payments reduces the benefits of borrowing to invest.

    Ed

  114. 119. JS

    FT,

    I believe I understand what you are saying in the original article. However, I do have a few niggling queries. Let me preface my questions by saying that I am a financial noob.

    1. Does the CRA require income from investments, not just capital gains? i.e. If I take out a loan of $1000 and invest in stocks that do not pay out dividends, the loan interest would not be tax deductible, correct?

    2. If I pay 5% interest on my $1000 loan ($50/year) can I invest only a portion of my loan in dividend paying stocks (to cover the $50/year in interest) and the rest of the loan in non-dividend paying stocks? Would this qualify for the tax deduction on the $50?

    Cheers,

    JS

  115. 120. FrugalTrader

    @ JS, CRA does not require income, but an ‘expectation’ of income. So capital gains is fine providing that the company could “potentially” pay dividends.

  116. 121. JS

    Thanks for the quick reply FT.

    Am I correct in assuming that mutual funds and index funds would not qualify for the deduction

    JS

  117. 122. FrugalTrader

    @JS, my understanding is that if the index/mutual fund is invested in equities, then the investment loan would be deductible.

  118. 123. Javed

    Hi All, after reading your site postings on Smith Manoeuvre, I started the manoeuvre back in September this year. I started with NBC all in one account and Questrade. I have $ 13,000 capitol gain and $ 400 dividends. Capitol gains are after selling the stocks. Can I withdraw the $ 13,000 and paydown the mortgage portion and still keep my HELOC tax deductible?

  119. 124. FrugalTrader

    Javed, as indicated in the article, if you were to withdraw $13k in capital gains, a portion of your deductible investment loan would decrease as well. You should consult an accountant for the full details. However, you can withdraw the $400 dividend without any implications.

  120. 125. Javed

    Ed Rempel in 115 wrote
    “You can also take the capital gains out to do whatever you want and still have the loan deductible. The general rule is that any taxable income can be withdrawn, but non-taxable payments like ROC will reduce the deductibility of the loan.

    The issue with capital gains is that you can only take out the actual gain, not an amount equal to the gain. You need to be able to track it.”

    I have actual gains after doing some very short term trading. I have details of all the transactions (trades). The year end is approaching and these capitol pains will be taxable. So if I paid taxes on it as income CRA should be happy to receive the taxes.

    Javed

  121. 126. shutupsitdown

    Is the interest from a brokerage margin account used to buy dividend and non dividend producing stocks tax deductable? Would it matter if it was US dollars? Specifically, it’s a Questrade margin account.

  122. 127. Jim

    FT,

    If I obtain distributions from a metals ETF and use those to re-invest in the ETF(without withdrawing) would I still keep the tax deductibility on the LOC?

  123. 128. FrugalTrader

    @Jim, I believe that as long as you don’t withdraw, you “should” be ok. Do you know what the distributions are? Are they dividends? If they are 100% dividends, you’ll not have any issues. Best to confirm with an accountant.

  124. 129. Ed Rempel

    Hi Shutup,

    They should all be fine. Whether or not the stock pays a dividend is irrelevant – unless it is structured so that it is prevented from ever paying a dividend. I’m not aware of any stocks like that, so essentially any stock should be fine.

    It is also irrelevant what country the stock is in, as long as it is a legitimate investment.

    Ed

  125. 130. Ed Rempel

    Hi Jim,

    If you leave all the money invested, then the type of income (capital gain, dividend or ROC) is irrelevant. The loan should still be deductible.

    CRA is concerned with the “current use” of the money borrowed to invest. If it is all still invested, then there should be no problem.

    Ed

  126. 131. Jim

    Thanks FT and Ed for answering my above query.

    Here’s a new one; got the first interest bill on the investment loan and I plan on capitilizing the interest. However, I noticed that my minimum payment is higher than the interest.

    Should I be capitalizing the minimum payment rather than the interest?

    My thoughts were to cap. the minimum payment – as long as the paper trail is clean everything is rosy, right?

  127. 132. Ed Rempel

    Hi Jim,

    Are you using an unsecured credit line for this? I take it you are not doing the SM, but are doing some other strategy? As far as I know, all secured credit lines and many unsecured credit lines have a minimum payment that is interest only.

    To answer your question – yes, you can capitalize the entire payment.

    Ed

  128. 133. Faisal

    Hello Ed (and others),

    I’m interested to know about how capital losses would be treated with an investment loan, a topic that was brought up in comments 54 and 55 on this page. Say I borrow and invest $10000, withdraw dividend payments periodically, and after some time my investment falls to $8000. I decide to withdraw $2000 for whatever reason. If it works the same way as capital gains, I would assume that I would need to pay $2500 to my investment loan in order to keep it 100% tax deductible since that was the cost basis for the $2000 proceeds. (This seems similar to selling a house that has negative equity.) Does this make sense?

  129. 134. Ed Rempel

    Hi Faisal,

    You need to pay onto the investment loan either the book value of the investments sold or the proceeds of sale – whichever is less.

    If you pay 100% of the proceeds of sale onto the investment loan, the loan should remain 100% deductible, even if that amount is less than the book value.

    Ed

  130. 135. Faisal

    Hello Ed, that’s very good to know! Is that stipulation buried somewhere in IT-533?

    Another question I had was brought up in the comments for one of these MDJ SM articles and I’m not sure that it was addressed. The question concerns writing out-of-the-money put options in order to acquire securities at the price point that I would like. I would write the options and keep collecting premiums with the intention of owning the underlying security that has a reasonable chance of paying a dividend (i.e. with the genuine intention to ultimately hold a portfolio of stock at my desired cost basis). If I continue collecting premiums until the end of the year without any contracts being exercised, my income would be taxable as capital gains (I think). Would the interest still be deductible for these investments?

    I suppose it might be safer just to buy one such security at market, and then write the options for other securities I might be interested in. Any thoughts?

  131. 136. Interest Issues

    I purchased some rental property, and needed to take out a loan to do so. I have been writing off the interest on this loan. Currently it is 85,000 at 4.0%. I am taxed in the 40% category. I have a chunk of cash I want to put somewhere, but I’m not sure if it’s better to put it on the loan, or if I should put on my mortgage (134,000 at 2.188% with a 14 yr amortization). Normally I try to pay off the mortgage first, but since the interest rate is so low, I’m wondering at what point it becomes more financially sound to start putting my large prepayments on the loan. Do I simply take the 4.0% x 0.4 (my tax bracket) = 1.6. Then 4.0% – 1.6% = 2.4%. If I’m right in this math, then it makes sense to pay the loan now since 2.4% is slightly higher than 2.188%.

    Please help!

  132. 137. FrugalTrader

    @Interest Issues – Yes, your math is correct. Traditionally, I try to hold onto “good” debt as long as possible, and pay off “bad debt” as fast as possible. When is your mortgage term up? What will your new rate be when you renew? That will be something else to take into consideration. For me, even though I had a very low mortgage rate on my principal residence, I just paid that off and held onto my investment loan.

  133. 138. Interest Issues

    @FrugalTrader:
    The mortgage is up in 4.5 yrs now, and I’m anticipating interest rates to be higher; however, because it’s fixed for the whole term, I feel more secure with it than my flexible rate I hold on my investment loan.
    The calculation that considers which is the best money saving technique (ie, prepay tax deductible loan vs mortgage) can definitely get confusing. For example, although the calculated interest rate is 2.4% on the tax deducitble loan, the loan itself is only 85,000. Does that mean it’s still the best bang for the buck to prepay the loan compared to the mortgage at 2.188% for 135,000?
    I’m curious because even though the interest rate is lower on the mortgage, the total cost is higher. Thoughts?

  134. 139. alexander45

    Interest Issues.

    The balance of the respective loans is irrelevant. Mathematically, the only variable that matters is the relative interest rates. Pay the higher rate first.

  135. 140. cannon_fodder

    Interest Issues,

    You’ve thought of it logically. Except for the additional point that FT brought up about a potential readjustment of interest rates, it is the after tax cost of servicing the loan, NOT the relative interest rates, that is the most important.

    That is why I was paying down a 1.75% mortgage faster than a 2.25% HELOC. The HELOC (which is compounded monthly and not biannually like the mortgage thus increasing the disparity) is deductible debt. It’s after tax servicing costs are closer to 1.2%.

    When you get really sophisticated, you use Excel to forecast, based on which loan you pay down aggressively, what your potential savings will be based on renewing at a series of interest rates. You can assign probability to each rate and then go from there.

  136. 141. Interest issues

    Thanks a lot guys, that helped me make my decision!

  137. 142. RandomUser

    I’m quite excited to read all the useful info on your site and thank you for the great work.

    I would like to leverage approx. 100k in home equity and would like to try SM. I do not have a mortgage currentIy, and just tempted by the tax deduction on the interest paid while invested. I m planning to invest it in a high div paying US stock. Now I understand i would lose Canadian div tax deduction and US IRA would certainly take their cut on my div first, but would the SM still work though? If IRA take their tax off, would I still have to pay another tax as it gets counted toward my world income for CRA in Canada? I intend to leave the HELOC invested for as long as I have this property under my name. What’s your take on this?

    Thanks in advance.

  138. 143. Ed Rempel

    Hi RandomUser,

    That’s a few questions. Your strategy sounds like it would be okay for tax purposes.

    However, you need to understand that the Smith Manoeuvre is a strategy of borrowing to invest, which is a riskier strategy. Borrowing to invest in one stock is highly risky.

    With the SM, you should consider more defensive investment strategies, such as being much more diversified.

    You should not focus too much on the dividend. Even if the dividend is higher than the interest cost, this is still a risky strategy. Any stock can fluctuate widely. A drop of 50% can easily happen in any individual stock, even with a high dividend.

    The main benefit is the long term growth of the investments, not the tax deduction. When we estimate the benefits for clients, typically the growth of the investments vs. the interest rate is 80-90% of the benefit, while the tax refund and reinvesting it is about 10-20% of the benefit.

    I find people get mesmerized by small benefits of dividends and miss the big benefit. If you buy investments that compound their growth over many years, the compound growth effect can give you a very large portfolio after 20+ years.

    It is also generally not advisable to restrict your investment choices to only dividend-paying investments. The best investment choice should be based on the risk/return and the quality of the investment. Whether or not it pays a dividend is only one of many very important factors in evaluating investments.

    Ed

  139. 144. RandomUser

    Thanks for the advice, Ed… totally agree with you on focusing on the long-term growth, not tax benefit but hey, if I could get the tax benefit while achieving long-term goal, why not? Another thing is that I am prepared to option up my stock positions to protect the downside of investing in one single stock, because, yes, it may go down by 50%. If optioned up, just a few stocks in the portfolio may be more manageable for myself.

    So I guess US investments are OK by CRA in term of this tax strategy right?

    One last question, if in my portfolio I have investments that not only yield dividends but also some just capital gains, I only get to deduct interest off the portion that yields only dividends as they are considered as providing income but the portion returning capital gains is not income, right?

    Thanks again for your response!

    R.U.

  140. 145. Ed Rempel

    Hi R.U.,

    To answer your 3 questions:

    1. Every option strategy has an advantage and a disadvantage. Make sure you understand both before you do it. For example, many investors try to protect the downside with a “stop loss”. I’m not sure they work well. Remember, if your stock falls quickly, your stop loss becomes a “market order” and is sold as soon as someone is willing to buy it. If you have a stop loss 10% below today’s price, but the stock falls 50% quickly on some bad news, you sell immediately at the 50% loss.

    Most of our fund managers don’t use stop losses. My opinion is that stop losses are a strategy marketed to amateurs in order to increase trading commissions. We call them “take loss”, not “stop loss”, since they determine the price at which you are willing to take the loss.

    Think of your house. Let’s say it is worth $500,000. Every day, many people make random offers and you mostly ignore them. Then someone advises you to setup a stop loss. Now, the first time a random offer is at $450,000, you want to sell quickly and automatically without thinking about it. Does that sound like a smart strategy?

    2. Yes, borrowing to invest in US investments is normally still tax deductible.

    3. You should be able to deduct all the interest. This is a common misconception. To be deductible, investments need to be theoretically capable of paying income – they do not actually need to pay it. Most mutual funds or stocks are fine, unless their prospectus forbids them from ever paying a dividend. I’ve been doing the SM for 17 years and have not received any dividends at all yet. It is 100% deferred capital gains.I do this to defer the tax until far into the future when I want to retire and live off the investments. I would rather not have to pay tax on dividends now.

    Ed

  141. 146. DazeTrader

    @discfree and @Faisal

    Did you guys ever find your answer regarding selling/writing put options to collect premiums, would this investment style still be applicable to receive the interest tax deduction? And what rate would this be taxed at (capital gains?).

    I would like to purchased dividend paying stocks and then sell covered call options as well to increase my investment growth even more.

    Thanks,
    @dazetrader (twitter)

  142. 147. Ed Rempel

    Hi Dazetrader,

    You can choose either to record them as income or capital gains, but then you have to use the same method for all options transactions in the future. This article explains it well: http://www.taxtips.ca/personaltax/investing/taxtreatment/options.htm . Read the entire article carefully, since you need to think through how your choice will affect any future options transactions you do.

    Before using any options strategy, make sure you understand it. In all options strategies, you gain something and lose something.

    For example, with selling covered call options, you gain the premium and you lose potential for larger gains. You have 100% of the downside of the stock (less the option premium), but your upside is limited to the option strike price.

    This strategy is normally popular during and after flat or down markets, but most investors lose interest as we move into the next bull market.

    Ed

  143. 148. Carlos

    I have a 70K dollars line of credit which I used in its entirety and exclusively to purchase a rental property; I have been deducting the interest (3.5%) generated as an expense, no problem there. Recently I receive a credit card check for which I can use up to 25,000 $ at 0% interest for up to a year; If I do use this 20,000$ to pay off some of my line of credit and then just before year is over i draw back from line of credit to pay back the credit card before it starts charging me with high interest will my line of credit interest remain interest deductible in its entirety?

  144. 149. Seymour

    If I take out a mortgage on my paid off house, and use the proceeds to invest in an second mortgages, is the interest on my mortgage deductible? I know on a line of credit it is, but not sure about mortgages.

  145. 150. Ed Rempel

    Hi Carlos,

    Yes. As long as you keep the money you borrowed separate are able to trace it directly to the investment property you purchased, you should be able to deduct it.

    Ed

  146. 151. Ed Rempel

    Hi Seymour,

    The key factor is the current use of the borrowed money, not the type of loan it is in. In other words, it is irrelevant whether the money you borrowed is a credit line or a mortgage, as long as you borrowed to invest.

    Borrowing to invest in 2nd mortgages would be a very high risk venture, though. If the mortgage holder decides not to pay, will you be able to buy out the first mortgage? If not, then you essentially have no security or ability to enforce payment.

    You would also not really be diversified.

    Remember, with 2nd mortgages, you are lending money to people that are so badly off that they need 2nd mortgages from private lenders, which generally means they cannot qualify at a bank or other financial institution.

    Ed

  147. 152. CG

    I have withdrawn money from a CHIP home income plan for a variety of purposes, and a substantial part of that borrowed money has been invested in a GIC. The return on that investment is less than the interest that is accumulating against that loan. Can I claim the difference as an investment loss on my 2011 income tax return, and if so, how?

  148. 153. Ed Rempel

    Hi CG,

    I just noticed your post. You probably have done your tax return by now.

    To answer your question, you can probably claim enough interest deduction to offset the GIC interest, assuming you can trace the money from the CHIP mortgage to your GIC. Claim it as a “carrying charge”.

    You borrowed to invest, but not in a way that offers any possibility of making a profit. I’m sure the GIC interest is far lower than your interest on your CHIP mortgage, so your deduction would be limited to the interest you earn on the GIC.

    If you invested in an equity or even a balanced investment, it is probably reasonable to claim all of the interest on your CHIP mortgage, based on the amount you invested.

    I hope this is not a long term strategy for you, CG. I doubt you can properly fund a retirement on GIC interest.

    Ed

  149. 154. Kinoli

    The smith manoeuvre sounds to me like the way to go. I have a question though. I am self employed and make a lot more than my wife does. Would it be smarter to use a margin account for the investments from the LOC in my wifes name rather than in my name because she is in a lower tax bracket than I am? So the dividend payments and capital growth would get taxed less.

  150. 155. Ed Rempel

    Hi Kinoli,

    No. In general, the Smith Manoeuvre investments should be in both your names for estate planning purposes, but taxed in your name only since you are in a much higher tax bracket.

    The interest deductions and the taxable investment income must be allocated the same way – to you, to your spouse, or to both. To decide who should claim it, you should take into account not only your taxable income this year, but what you expect it to be for you and your wife for the next few years (or for as long as you plan to maintain the Smith Manoeuvre).

    Once you decide who will claim it, you should always claim both the interest deduction and the investment income on that person’s tax returns.

    If you invest reasonably tax-efficiently, the interest deduction should be more than the taxable investment income in most years. If you expect that to be the case for you, then you should claim the Smith Manoeuvre on your tax return.

    You are self-employed. That often means you have expenses to offset your income or if incorporated, then you have some flexibility in how much taxable income you show. Is your taxable income also much higher than your wife’s?

    Ed

  151. 156. Kinoli

    Hi Ed, thanks for the reply. Yes, I am incorporated and I use dividends to lower my taxable income, plus I pay my wife a wage, however my wage is a lot more than hers but both are in a reasonable range, her’s is about half of mine. I’m not clear as to how to setup the accounts. We already have a mortgage with CIBC that has a LOC attached to it that grows as we pay down the mortgage. I also have a Questrade margin account that I could use for the Smith Manouver, however I don’t think my wife’s name is attached to the account. I’m not sure if you can do that. I was thinking of maybe creating a QT margin account for her, since she is in a lower tax bracket, so any gains on the LOC investments would be lower. Are you saying that isn’t a good idea? Thanks a lot.

  152. 157. Kinoli

    Sorry, the questrade account is actually a joint margin, so she must be associated with it. So maybe that account would work best.

  153. 158. CD

    Can someone tell me how the following would be viewed in terms of maintaining tax deductibility?

    - Borrow $15,000 from LOC (with intention of deducting interest)
    - Immediately invest $15,000 in eligible stocks through broker margin account
    - Make no other transactions except later on, borrow $5,000 from margin account (secured by stocks) and spend on vacation
    - Later on repay the margin account from disposable income

    Does tax deductibility still remain intact on the original borrowings on your LOC?

    Thx, c.

  154. 159. FrugalTrader

    @CD, i’m not sure, but I think a better plan would be to save for vacation using disposable income, then go on vacation when you have the cash.

  155. 160. CD

    FT: I was just using vacation as an example.

    Let’s say the margin use was used on something else a little less discretionary. In this case, I’m just trying to figure out if the original loan would still maintain it’s deductibility status…

    Anyone know?

  156. 161. Ed Rempel

    Hi Kinoli,

    Sorry, I didn’t see your old post #156. Yes. It is better to have the Smith Manoeuvre taxed in your name, so that you can get the higher tax savings for deducting the interest.

    If you invest for dividends, your wife would pay less tax, but you lose that benefit because then you have to claim the interest deduction on her return at the lower rate.

    If you are in a high tax bracket, then you may be better investing for deferred capital gains.

    I’m not sure what you mean by “I am incorporated and I use dividends to lower my taxable income”. The dividends would be grossed up and are deductible to your corporation, so that would make your taxable income higher for both you and your corporation.

    You may have other options, since you are incorporated. Is your wife a shareholder? Can you pay her dividends from your corporation in order to split income?

    Ed

  157. 162. Ed Rempel

    Hi CD,

    If I understand your example correctly, your interest on your LOC would still be tax deductible, but not the margin account.

    I assume you are using the $15,000 from the LOC to buy the stocks, not $15,000 borrowed from your margin account? If so, then your LOC was always used only for a tax deductible purpose. When you borrowed from your margin account for a vacation, that margin account was only used for the vacation, so it would not be deductible.

    If you co-mingled the borrowed money, you can still be okay. You can use the “flexible approach”, as explained in IT-533, to designate which portion of your margin account you paid off when you paid the $5,000.

    You do have to track all the transactions and pro-rate any interest charges between deductible and non-deductible if you co-mingled your money.

    Ed

  158. 163. CD

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

  159. 164. Michael

    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”?

  160. 165. Nikolai

    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?

  161. 166. FrugalTrader

    @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.

  162. 167. Ed Rempel

    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

  163. 168. Brown

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

  164. 169. Suprbeast

    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’).

  165. 170. Monica

    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?

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