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.
- 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.