If you sell a property, you need to pay off the Cash Dam credit line. If you don’t, then it stops being tax deductible. This is similar to the mortgage against that property.

You are right that you need to keep track of each property separately. With real estate, each property is tracked separately on your tax return. Most other assets are pooled by CCA class, but real estate properties are each tracked separately.

Ed

Comparing Cash Dam to investing in a corporation, both strategies have merit. The better one is different in each case, depending on how much of the strategy you can do.

The topic is complex, but here are some high points.

1. The Cash Dam only works if you are NOT incorporated. It converts non-deductible debt to deductible debt based on the amount of business expenses you have. If you have a consulting business, you may have very little in expenses, so the benefit is small. Other types of businesses have higher expenses, so it would be a bigger benefit.

We had a contractor client that made $100K, but he had $500K gross with $400K in expenses (including subcontractors). That means we could convert $400K of debt to deductible each year. We converted his mortgage and a large RRSP loan to tax deductible in less than a year. Converting an RRSP loan to deductible is cool!

The savings here are the the interest deduction. If you convert a $400,000 mortgage @2.5% interest to tax deductible, you can deduct $10,000/year for as long as your business is active and make enough profit to deduct it against.

If you are also doing Smith Manoeuvre or Rempel Maximum, then you would already be converting your mortgage to tax deductible. The Cash Dam will convert it faster, but then the savings from the Cash Dam are for a shorter time period.

2. Investing inside the corporation – Corporations have a lower tax rate of about 15.5% on the first $500,000 of active business income, but not investment income. A good strategy sometimes is to leave money in the company with the lower tax rate, which gives you a larger amount to invest.

This strategy is a tax deferral – not a tax savings. It works generally to the extent that your company generates profits that you plan to invest and not use for your lifestyle.

For example, let’s say your company has a profit of $200K, but you only need $100K for your lifestyle expenses. This means you can leave the extra $100K in the company. You will pay 15% corporate tax, which leaves you $85,000 to invest.

If you had taken that $100K out of the company, you would have paid tax at your marginal tax rate, which could be 33% or 46%. If you are in the highest tax bracket (46.4% in Ontario), then you would only have $54,000 left to invest vs. $85,000 if it is in the corporation.

This sounds great at first, but this is only a deferral. At some point, you will want to withdraw the money and then you have to pay the extra 31% tax.

In addition, investment income in a corporation is always taxed at the highest possible rate unless you pay it out to yourself personally. Usually, you would end up paying personal tax on the investment income.

Looking at the numbers makes it clearer. This is a very over-simplified example, but gives you the concepts.

You can invest $85,000 inside the corporation of $54,000 outside. After 7 years, let’s say your investments doubled. So you could have $170,000 inside the corporation or $108,000 outside.

Now you sell. Inside the corporation, you would have $170,000 which you withdraw and pay 31% tax on. (The corporation gets a refund of 15% and you pay 46% personally.) That leaves you $117,000.

You would probably pay personal tax on the capital gain of $19,500 ($85,000/2×46%), which would leave you $97,500.

Compare this to owning the investment personally, where you have $108,000 to invest. You pay capital gains tax of $12,500 ($85,000/2×46%), which leaves you $95,500.

You end up with similar amounts. Note there was a tax deferral, but when you eventually withdraw, you pay tax the extra tax on the higher amount that the investments grew to. In both cases, you would probably pay personal tax on the investments.

Normally, investments in a corporation should be very tax-efficient. Some corporate class mutual funds allow you to invest with little or no tax until you sell in the future.

This strategy works better if:
A. You have a quite a bit of money that you do not spend and can leave in the company.
B. You can expect to have future years in lower tax brackets when your business is still active, so you can withdraw money then.
C. Your business is the type that you plan to pass on the next generation. If the business stays active after you retire, you can keep the deferral going far longer.
D. You have family members that you may be able to split income with.

There are a variety of other factors that affect the decision of whether or not to use a corporation. For example:

- Risk of being sued (business of personal), since the corporation provides some protection.
- Tax planning. Options to pay yourself optimal amounts every year, plus giving you the choice of salary, dividends or profit sharing.
- Possible income splitting to family members, using different share structures, an “estate freeze”, or a profit sharing plan (EPSP).
- EPSP also allows you to effectively opt out of CPP, which is a poor investment.

Accountants tend to know the main issues, but tend to focus on which one results in lower tax in year 1. They tend to not know about EPSP, Cash Dam, Smith Manoeuvre, Rempel Maximum, or effective investments inside a corporation, and accountants often don’t realize that CPP is a bad investment.

You need to look at tax over your lifetime and to what degree you can benefit from each strategy to see which one works better for you.

Ed

Has anyone studied this to see under what conditions which scenario is better financially?

That is a loaded question. I will be interested to hear if anyone has an answer.

Nathan

As tax rates for corporations are much lower than for sole proprietorships (which use personal tax rates I believe), when does one strategy beat out the other?

@ Accidental Landlord, same as GC. If you take out a line of credit that’s solely for investments, then you can use it to pay off your condo investment mortgage and still deduct the interest from the LOC. That is providing that you never withdrew from your condo to purchase your new principal residence in the first place. If you did, then that’s a whole new kettle of fish!

I’m interested in hearing the responses to GC’s question above, as well as to a slightly different situation below. I’m wondering whether this means that I can make the principle portion of my rental property tax deductible as well??

Here’s the scenario:

I own a primary residence and a rental property (condo – former residence). The condo has $60,000 left on the mortgage, and brings in $1600/month in rent. I currently deduct the operating expenses (mortgage interest, condo fees, property tax, insurance, maintenance…) from the rental income.

Now, if I were to take out a line of credit and pay off the $60,000 mortgage, would any payments I make to the line of credit be tax deductible as well??

Thanks!
Accidental Landlord

Would the main advantage be paying down my personal residence quickly, and being able to claim the interest on the HELOC? Basically just a transfer of the mortgage….
Does it make sense to do this when my principal residence rate is 2.1% (prime – .90) and the HELOC is at 3.5% (prime + .50)?
Any comment on capitalizing the interest from the rental HELOC?

Thanks, GC

Thinking from a bookkeeping perspective, would this be classified as a loan repayment or a draw on owners equity?

I am starting a portable welding business soon and would very much like to implement this strategy; the business is very capital intensive early on.

Could I use my up-front capital purchases as an expense?

If I understand correctly, I would cut a check from my HELOC to pay my $2,000 / month business expenses. Then, as income rolls in I could withdraw the income to do with as I please, this includes paying down my mortgage (if I want). I assume the only complexity in doing this with a partnership is the split of expenses (50/50 etc..).

Is the key here to only “loan” the business money for expenses?

If implementing the SM and CFD (Cash Flow Dam) would I need a sub-account on my HELOC?

Thanks in advance!

However, if you are simply using your office to invest, I do not believe you can claim it as an expense – unless you are a full time trader. But full time traders would need to claim their gains as income instead of cap gain.

Also, what can you expense with the SM? I am thinking of purchasing a computer, since I need it to purchase my dividend stocks. Does this qualify as an expense? I will speak with my accountant of course, but I am trying to get an idea of what I can and can’t do.

Wow, those are high mortgage rates. I would suggest to consider paying the penalty to get out of both mortgages and refinance at today’s low rates before starting the Cash Dam. Then you can also get readvanceable mortgages (assuming you don’t have them now).

I would suggest to call both mortgage providers to confirm what the penalty is. You can get a 1-year fixed between 2.5-2.6% today. Depending on your penalty, if it is only 3-months’ interest, then you would still save about 1.25%/year over the next 16 months till your mortgage would come due.

On the variable, the penalty is almost always just 3 months’ interest and you can get a variable at 2.15% today, which is about 1.5%/year lower than your current mortgage.

Once you refinance and get good rates, then it is more obvious that paying down the non-deductible mortgage is the better choice.

The other thing to keep in mind is that your rates today are not that important of a factor. The Cash Dam will convert your non-deductible mortgage to deductible over time and the interest is deductible not only this year. Once you convert it, it is deductible every year that you own that property.

Even if your penalty is too high and it is not worth refinancing today, you will likely have your mortgage for many years. The tax savings over 20 years (say) can be quite a bit more than the interest differential in the next year or 2 until your mortgage comes due.

Ed