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The Cash Flow Dam (Cash Damming) Explained

For the Smith Manoeuvre and tax minimization enthusiasts out there, you may have heard about The Cash Flow Dam (or cash damming).  Cash Damming is a fancy phrase for a fairly simple concept that can help optimize your taxes if you have a mortgage and a personal small business.

What is The Cash Flow Dam?

The Cash Flow Dam is tax arrangement that allows a personal small business owner (sole proprietor/partnership) to pay down their non-deductible mortgage faster.  In other words, it is a variation of the much discussed Smith Manoeuvre, without the investing, that helps convert bad debt into good debt.

How Does it Work?

Cash Damming uses a line of credit to pay for business expenses while taking the increased business cash flow to pay down a non-deductible mortgage/loan.  This results in a growing tax deductible business loan, and an accelerated pay down of a non-deductible mortgage.  This only works with a non-incorporated/personal/partnership small business.

For example, say you had a small business with $1,000/month in expenses and a readvanceable mortgage.  The $1,000/month expense would be paid by the home equity line of credit (HELOC), and the extra $1,000 sitting in your business account now would be used to pay down your non tax deductible mortgage.  The key to this strategy is that interest paid on borrowed amounts used for personal business expenses are tax deductible.  In the end, you’ll have a large tax deductible business loan and no mortgage.

Some of you may be thinking that this new loan just created a new monthly interest expense in addition to the existing mortgage payments.  The new interest expense can be avoided by capitalizing the interest.  That is, use the business line of credit to pay for itself which keeps the account tax deductible while using $0 of your own cash flow.  You can read more about capitalizing the interest here (with diagram).

How is Cash Damming different than the Smith Manoeuvre?

Cash damming uses business expenses to enable the loan to be tax deductible whereas the Smith Manoeuvre uses investments.  The Smith Manoeuvre is on the riskier side as it involves leveraged investing into public equities.

Applications

  • Rentals – If you are a rental investor, instead of using your own cash flow to pay for expenses, cash damming would involve using a line of credit instead.  This strategy will essentially allow your rentals to pay for your personal mortgage while keeping the tax man happy.
  • Self Employed/Side Business – If your personal company isn’t incorporated, and your monthly expenses are fairly high, then the cash flow damn can convert your non-deductible mortgage into business loan fairly quickly.  The net after tax result is a much lower overall interest cost.

I’m not a tax professional. Any information in this article should be taken for its entertainment value only.  A professional accountant should be consulted before implementing the strategy above.

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FrugalTrader About the author: FrugalTrader is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.

{ 109 comments… add one }

  • Ed Rempel December 10, 2014, 1:00 am

    Hi Nabeel,

    The answer to your question is: probably. You are referring to the “aggressive approach” in which you co-mingle funds, but keep a precise record of each. In general, if you records are accurate, it should be fine. However, what will you do if there are deviations, such as changes in interest rates, lump sum payments, or some other variation.

    It sounds like your real issue is dealing with the wrong financial institution. Every institution I have seen has identical rates for conventional and readvanceable mortgages. If you have someone trying to persuade you to go with a conventional mortgage, it may be a mortgage broker, since they have limited access to readvanceable mortgages.

    We have a free mortgage referral service on our web site, if you want a referral to today’s lowest rate and a readvanceable mortgage.

    Ed

  • nabeel December 10, 2014, 2:29 pm

    Ed,

    I did fill up the mortgage referral form on your website and will explore whatever options are presented, but one of my main concerns with the AIO type of products is that the entire line (mortgage + LoC components) is shown on my credit report as a secured LoC. So, in my example, my $210K mortgage plus $36K LoC, both part of my AIO, are reported as a $246K balance on my Equifax and Transunion reports.

    I used to be a heavy CC churner, and my instant approvals are few and far between in the last 3 years of holding this NBC AIO product.

    Are there are AIO type products that do not report the mortgage component as a regular credit line?

  • Mark In Kingston December 16, 2014, 8:07 pm

    Wow this can be a huge long run tax savings. So if I keep borrowing for the expenses after my principal residence mortgage is done, (but using it and the rental property as collateral for these Heloc debts) investing in resp/tfsa and rsp (making those debts tax deductible) is there a limit in how high I can go? Market value of the house or as much as I can borrow.

    If it matters, principal residence is worth 300 000 and my rental is worth 250 000

  • Mark In Kingston December 16, 2014, 8:12 pm

    Because in theory the bank will lend me 80% percent of each (440000 based on today’s values) but does it really make sense to deduct interest from 440000 in debt on a 250000 property?

  • Nak March 5, 2015, 5:35 pm

    Good question Mark,

    Can someone answer his question?

    Can we have 440k$ deductible debt on a 250k$ property? Because I am doing the cash damming with my rental. The total debt against the rental is almost 90%. What is the limit that I can go?

    Thanks.

  • ottawaGUy2 March 13, 2015, 11:35 am

    Ed, could you please answer the above question?

  • Ed Rempel March 15, 2015, 12:09 am

    Hi Mark, Nak & Ottawa,

    There is no specific limit to how much debt you can make tax deductible with the Cash Dam strategy. It can be more than the value of the rental property. In fact, in general the Cash Dam works better with non-incorporated businesses than with rental properties. We have had cases where the tax deductible debt is several times the gross sales of a business.

    When you get creative, it you can do some amazing things. For example, you can borrow to contribute to your RRSP and get a nice refund, then use the Cash Dam to convert the debt to tax deductible. Essentially any debt can be converted to tax deductible, if you do it right.

    There are 2 main limitations:

    1. Unreasonable interest deductions. Your rental or business could be considered a hobby by CRA, if you start showing losses year after year. If your interest becomes so high that you show losses with no clear prospect of becoming profits, then CRA might deny all the losses. A property or business that does not eventually produce taxable income is generally not considered to be real.

    Also, if the interest deduction is unreasonably high, you could be essentially asking for an audit.

    2. You still owe the money and pay the interest. The Cash Dam can convert a debt to tax deductible, but you still owe it. You have to look at your overall financial situation and tolerance for debt. If it does not make sense to have debt, then making it tax deductible still may not make it smart or appropriate.

    Ed

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