Million Dollar Journey

1. 1. Blain Reinkensmeyer

   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!

   Apr 3rd, 2007 @ 1:02 pm

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?

   Apr 3rd, 2007 @ 2:00 pm

3. 3. Monty Loree

   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

   Apr 3rd, 2007 @ 2:14 pm

4. 4. Jon Lee

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

   Apr 3rd, 2007 @ 7:29 pm

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

   Sep 20th, 2007 @ 4:34 pm

6. 7. FrugalTrader

   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.

   Sep 20th, 2007 @ 4:41 pm

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?

   Sep 20th, 2007 @ 5:53 pm

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.

   Sep 21st, 2007 @ 10:19 am

9. 10. FrugalTrader

   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.

   Sep 21st, 2007 @ 10:24 am

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…

    Sep 21st, 2007 @ 11:47 am

11. 12. FourPillars

    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

    Sep 21st, 2007 @ 2:51 pm

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?

    Sep 24th, 2007 @ 1:55 am

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

    Nov 2nd, 2007 @ 2:51 am

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?

    Nov 16th, 2007 @ 12:14 pm

15. 17. FrugalTrader

    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.

    Nov 16th, 2007 @ 12:20 pm

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…

    Nov 19th, 2007 @ 1:45 am

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.

    Nov 19th, 2007 @ 1:55 am

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.

    Jan 24th, 2008 @ 5:05 pm

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

    Jan 25th, 2008 @ 12:00 am

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.

    Jan 28th, 2008 @ 11:32 am

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!

    Jan 30th, 2008 @ 8:40 pm

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

    Apr 20th, 2008 @ 2:19 am

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

    Apr 20th, 2008 @ 12:28 pm

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

    Apr 23rd, 2008 @ 1:32 am

25. 28. AMeer

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

    Apr 23rd, 2008 @ 1:17 pm

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.

    Apr 24th, 2008 @ 10:12 pm

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

    Apr 24th, 2008 @ 11:42 pm

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.

    Apr 25th, 2008 @ 12:54 am

29. 32. FrugalTrader

    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.

    Apr 25th, 2008 @ 7:41 am

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!

    Jul 21st, 2008 @ 1:44 pm

31. 35. FrugalTrader

    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.

    Jul 21st, 2008 @ 1:51 pm

32. 36. Lou

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

    Jul 29th, 2008 @ 1:05 pm

33. 37. FrugalTrader

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

    Jul 29th, 2008 @ 1:34 pm

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

    Jul 30th, 2008 @ 2:37 am

Trackbacks

1. The Smith Manoeuvre - A Wealth Strategy (Part 2) - Million Dollar Journey - Jun 22nd, 2007
2. Which Spouse Should Claim the Investment Loan? | Million Dollar Journey - Sep 25th, 2007
3. The Smith Manoeuvre Money Flow | Million Dollar Journey - Mar 10th, 2008
4. Smith Maneouvre Portfolio - June 2008 | Million Dollar Journey - Jun 30th, 2008

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