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The Cash Flow Dam (Cash Damming) Explained

Written by FrugalTrader on Nov 24, 2008 filed under Smith Manoeuvre

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.

18 Comments, Comment or Ping

1. Four Pillars

Good explanation - I didn’t know what that was called. I was debating on doing something similar for my blog next year since I have relatively high expenses (for a blog) - Mr. Cheap doesn’t come cheap and my wife also helps out and is on the payroll.

Nov 24th, 2008 @ 10:16 am
2. FrugalTrader

Great idea FP. Have you looked into incorporating your online business?

Nov 24th, 2008 @ 10:31 am
3. Four Pillars

I’ll consider it but for now the revenues are too low to make it worthwhile. Hopefully that will change in the future. :)

Nov 24th, 2008 @ 11:08 am
4. nobleea

So how does it work for rentals. Is the entire mortgage payment (P+I) considered a valid business expense? Or just the interest? Or is is the full amount and then you pay taxes on the capital gain when you sell (if you do)

I suppose it’s much easier if you have a seperate LOC for tracking. I wonder how hard the paperwork would be if you used a LOC that you also used for other purposes.

Nov 24th, 2008 @ 12:04 pm
5. FrugalTrader

Nobleea, AFAIK, any interest paid to service a business loan is also tax deductible. So I can’t see why you wouldn’t be able to use a line of credit to pay the rental mortgage. However, with that said, I’m not sure that you could capitalize the interest on that LOC because that would be 3 layers.

IMO, any LOC used for business/investing should be kept separate.

Nov 24th, 2008 @ 12:08 pm
6. Four Pillars

You absolutely HAVE to keep any LOC used for business separate from any personal use. I got caught on this one last year because my former bank (TD) screwed things up. I had to sell some stock, wait 30 days and rebuy. I didn’t get audited or anything like that but it was still something I had to deal with.

The problem with mingling funds is that if you make any payments to the principal, it is not clear whether you are paying down the deductible debt or the non-deductible debt. This is not something you can “designate” or assume it is in proportion to the amounts of deductible and non-deductible debt.

Nov 24th, 2008 @ 12:37 pm
7. nobleea

yeah, that makes sense.

is it possible to split an existing LOC in to two accounts? it’s a HLOC so it’s registered against the property.

also, does it matter if the LOC used is against the rental property? or is that just using your equity how you see fit?

Nov 24th, 2008 @ 12:43 pm
8. Four Pillars

Good question about splitting the LOC - I think this is dependent on the product you use. I have Firstline Matrix which does not allow sub-accounts but I know there are other LOCs out there which do. I suppose one could pay the fees and get another secured LOC set up.

I don’t think it matters how you use the money from the LOC - as long as it is used for investment in businesses of some sort. Stocks, rental properties, blogs, any other business - they are all eligible.

On an unrelated topic - if you have capital losses from stocks - is there a limit to how many years you can carry it forward?

Nov 24th, 2008 @ 1:10 pm
9. nobleea

FP;

Don’t quote me, but I think capital losses can be carried back 3 years and carried forward indefinitely?

Nov 24th, 2008 @ 1:13 pm
10. mjw2005

Is this not just robbing Peter to pay Paul…I am trying to wrap my head around this. Forgive my ignorance here. I am self employed but have very little overhead so this may not apply to my situation….

What do you mean by capitalizing the loan…..I get your diagram in relation to someone using borrowed money for Stock Investments….but how as you say does one capitalize the loan for a small business so that the small business pays the loan itself with you paying nothing…..I don’t get it…confused…..

Nov 24th, 2008 @ 1:57 pm
11. FrugalTrader
mjw,

This is basically what happens:
1. Business has expenses
2. LOC pays business expenses
3. LOC has interest owed
4. Pay LOC interest with chequing account
5. Withdraw same amount from LOC back to chequing account
Make sense?
Nov 24th, 2008 @ 2:00 pm
12. FrugalTrader

FP, nobleea is right on the money.
http://www.taxtips.ca/filing/capitallosses.htm

Nov 24th, 2008 @ 2:12 pm
13. Four Pillars

MJW - yes, you are robbing Peter to pay Paul, however if Peter can’t write off the interest and Paul can, then there can be some benefit.

Nov 24th, 2008 @ 4:39 pm
14. The Financial Blogger

Quite interesting strategy. I actually have a few client that has it in place (mostly with rental properties) and it works perfectly.

In fact, I wonder when do government get taxes from rental properties income? There are so many ways to avoid/defer taxes with rental properties :-)

There are a few banks offering HELOC with split accounts.

Nov 24th, 2008 @ 11:21 pm
15. Kevin

Hi Everyone,

I’ve been looking into this quite a bit the past couple of days. Here are 2 links with valuable info. One is just another explanation of how to do it, the other is a link to the CCRA’s website with their explanation and the rules on it.

http://howtobesetforlife.com/Reports/CashFlowDam.pdf

http://www.cra-arc.gc.ca/E/pub/tp/it533/it533-e.pdf

Hope this helps a bit

Nov 25th, 2008 @ 5:17 am
16. Kevin

oh and MJW,

you are Robbing Peter to pay Paul but you are paying down the principle on your own mortgage which eliminates your personal debt quicker. At first it’s not the easiest thing to understand but if you consider that the income doesn’t dissapear and your overall debtload is decreasing at the same pace as it previously was but you are transferring your bad debt to good debt.

Nov 25th, 2008 @ 5:24 am
17. cannon_fodder

Just a note… I created a Smith Manoeuvre calculator some time ago and the link has been located on this website. http://home.cogeco.ca/~pgannon/investment/Readvanceable_Mortgage.xls

It supports the use of Cash Damming if you want to see how it may work in your particular situation.

Cash Damming can be, obviously depending on how large your business expenses are, the fastest way to convert your non-deductible mortgage into deductible debt. This could easily save you thousands of dollars per year for many years.

Nov 25th, 2008 @ 10:09 am
18. Elbyron

1. Can I use the HELOC to pay for the principal portion of the rental property’s mortgage, or am I limited to using the HELOC only for expenses that are already considered tax-deductible, such as the interest portion of the mortgage?

2. Is the interest on funds borrowed to pay a down-payment on a rental property considered to be tax-deductible? (I would draw from a HELOC on my principal residence)

3. Which spouse can claim the tax deduction for a jointly-borrowed HELOC? If this is based on who is on the title for the rental property, then what are our options if we’re both on the title?

Feb 6th, 2009 @ 2:53 pm