Converting a Principal Residence into a Rental Property – The Solution!

No, your example is not correct. The CCA is “recaptured” first.

You claimed $100,000 CCA in total, so the first $100,000 of the sale price is recaptured CCA which is fully taxable. Then you have a capital gain based on the difference between the $200,000 sale price and the $100,000 original price.

Therefore, you end up claiming $150,000 income on your tax return ($100,000 recaptured CCA + $100,000/2 capital gain).

The CCA in effect is a deferral, not a deduction.

Whether or not it is worth claiming the CCA depends on your tax bracket in the years you claim CCA vs. your tax bracket on the recaptured CCA when you sell – plus the time value of money from getting your refunds each year and then paying it back later.

If you sell after you retire and are in a lower bracket, then you benefit. However, if you have a large recapture plus capital gain, you could end up being in a very high tax bracket.

In your example, you add $150,000 to all your other income for the year, so the recapture would be tax at the highest tax bracket. If you are in a lower tax bracket now, it might not be worth claiming the CCA.

Ed

I just noticed your post. The problem with your idea is that whenever a ROC distribution is paid out, the price per share declines the amount of cash you receive. You don’t lose units, but the price/unit declines.

Then if you reinvest, you have additional units (9% in your example), but they are worth 9% less for each unit, so your total dollars invested remains the same.

Your strategy actually does nothing. The amount invested remains the same. Your ACB also remains the same.Nothing has changed.

The only relevant figures in the strategy is the return on investment of the fund, the interest you paid on the loan and the tax consequences.

In short the distribution is irrelevant.

That is why you should choose your investment strictly based on the risk/return profile and how it fits with your goals. Any distribution has tax consequences, so it is best to try to avoid distributions as much as possible.

The best case scenario is a 100% tax-efficient fund(s) with zero distributions of any type for many years – with the fund(s) also being the best choice based on risk/return.

The big mistake is restrict your investment choice to funds paying a distribution.

Ed

If I understand it correctly, it is taxed 100% now but you only pay tax on 50%. Am I correct?

Example:
Initial cost = $100,000.00
Assume your claimed CCA (10 years or what ever time period) =$100,000.00
Net cost = 0 (after above time period)
Now you sold the property at price = $200,000.00
Capital gain = $200,000.00
Now you are taxed at 100% (i.e 200,000.00) but you only pay tax only on 50% (i.e. $100.000.00) of the gain because capital gain is taxed at 50%.of the gain amount.

Am I correct?

Throughout this discussion on the SM, a few people had presented investment strategies that include Return of Capital (ROC). In some of the examples that our bloggers have submitted, you have dismissed some of these funds because you say that they are unsustainable and for some, it is probably the case. But some funds like the IA Clarington Cash Distribution Funds seem, at least in my mind, sustainable.

Here is quick snapshot at one of them:
The IA Clarington Cash Distribution Funds have distribution rate of ROC that varies typically between 5-9% with a NAVPS these days between $4-8. The funds have a compound annual return of 4-5% in the last 10 years. IA Clarington has been pretty good at maintaining their distribution rate at least since 2002.

I think with these funds the focus should be on the cash flow it generates as oppose to the fluctuation in the NAVPS in the long term.

Here is a scenario, to illustrate what I’m trying to say:
Let’s say that you want to invest in one of those funds using some leverage. You invest $100,000 of your own money and get a 3 for 1 loan from B2B Trust (you pay back the interest only at prime +1% = 4%) so that you have $400,000 to buy units in one of those funds. $400,000 will get you 50,000 units at a NAVPS of $8.00/units. The distribution rate you get is $.061/unit/month = $0.732/unit/year which amounts to $36,600 in distribution per year (50,000 units X $.732/unit/year). In this example, the distribution rate would be $0.732/$8.00 (or $36,600/$400,000) = 9.15%. Not bad!

Meanwhile, you will pay about $12,000 ($300,000 X 4%) in interest during that year. You will have to re-invest all of your distribution in the fund in order to be able to claim the full $12,000 of interest in your tax return year after year otherwise it will affect the interest tax-deductibility of your loan. The other interesting aspect of that fund, besides its tax-efficiency, is that it allows for monthly cash flow through return on invested capital without redeeming fund units or triggering capital gains. So in fact, what this means, is that you are increasing the total number of units invested in your portfolio by an amount equal the distribution rate (here by 9%) and thus benefiting from the compounding effect.

You could do this for a number of years without affecting your adjusted cost base (ACB) if you are to re-invest all of the distribution into the fund. Your ACB will be reduced by the amount of any returns of capital not re-invested into the fund. If your adjusted cost base goes below zero, then you will have to pay capital gains tax on the amount below zero. You would also trigger capital gains if you were to sell any of your units (at the marginal tax rate at the time you selling them), but if you plan to retire in about ten years, you could just let them sit for a while and start cashing them only once you retire and when your tax bracket is much lower.

Finally, the only time you should worry about the NAVPS, is when you are ready to start selling some of your units (ideally only once you have retired and thus are in a lower tax-bracket). The goal would be obviously to sell them at a NAVPS that is higher than you have paid for them on average over the last ten years as you were building up your portfolio.

Ed, does this look like a sound investment strategy?

Thanks

PC

While I do not disagree entirely, I still have a few points I would like to mention (at least this is how I view it personally):

- depending on where do I get money for investments and where do I put them, I choose different investments. This is one problem I see with your analysis. When doing SM I invest using borrowed money. Thus, I am more concerned about the partial loss of the principal, not mentioning the complete loss. And, by the way, not all investments are eligible for the tax credit anyway. So, I can buy, say, Kraft Foods on the borrowed money as this is a well-known and quite stable company paying dividend. When investing in TFSA, I am not interested in a single-digit annual return. There is little point in investing in TFSA to earn a few % tax free. In order to really take advantage of TFSA, you need to make enough (if possible, of course). This implies higher risk.

- with SM there is one additional risk to consider – the interest rate risk. It applies mostly if you intentionally keep your investments leveraged and pay only the interest. In case of rapid interest rate growth you will need more income from your investments to keep the balance positive. Again, this is not a show-stopper at all, this is just a risk factor to consider.

- speaking of tax efficiency, again it comes to the choice of the investments. One chooses different investments for different situations, thus the end result may be different.

Bottom line: I suggest people to do both if possible. If you think you can make decent money in TFSA, then absolutely – do TFSA in addition to paying off the debt. I try to make as much as I can in TFSA to withdraw some excess cash by the end of the year, then use this cash to pay off part of the mortgage, borrow the same amount for investments from HELOC and then replenish my additional contribution room in TFSA in the beginning of the year. So far it worked fine for me.

We have found that the Smith Manoeuvre is almost always more effective than a TFSA. If you have $5,000, you could invest in an a TFSA. If you are doing the Smith Manoeuvre, you could instead pay the $5,000 onto your mortgage and the reborrow to invest. Which is better?

In both cases, you can buy the same investment, so the investment return is the same.

The difference then is that the Smith Manoeuvre also converts $5,000 of your mortgage into a tax deductible credit line. The interest on this credit line is tax deductible not only that year, but every year in the future that you maintain it.

The partly offsetting advantage of the TFSA is that the investment growth is tax-free, while it is taxable with the Smith Manoeuvre. If you choose a tax-efficient investment, you can defer the tax far into the future, though, which minimizes the advantage for the TFSA.

In short, the difference is mainly just the tax consequences. With the Smith Manoeuvre, you can create a tax deduction that you get every year for life. You will pay some tax on the investment growth, but it is possible to defer that far into the future.

Ed

I would not call TFSA new ;) In this ever-changing world something that exists for 2+ years is not new.

Since SM is about making a loan tax-efficient and TFSA is about being tax-free the question does not make too much sense.

I think the only thing to consider will be the return you can achieve on your money. Assuming you have a choice between paying off your bad loan (saving interest) and borrowing for investment (making $$$, paying taxes, deducting the interest on the loan from your income) vs. investing the same money in TFSA to make $$$. If you are genius investor and you can make very decent return, I think sheltering it from the taxes completely is better than saving on taxes. Otherwise – you need to do calculations. You can borrow to invest in TFSA, but the interest on this loan won’t be tax deductible.

The issue relates to the difference between good debt and bad debt. I agree with the last posts that your mortgage is paid off, but it is replaced by a tax deductible credit line from money borrowed to invest.

The SM does not require any of your cash flow while you have the mortgage, but once it is paid off, you have to pay the credit line interest yourself. However, it is interest only and fully tax deductible.

Your mortgage is “bad debt” that you should eventually pay off, but the investment credit line can be “good debt”. “Good debt” is debt that you are better off having than not having, because it was used to invest and the investments should make quite a bit more than the credit line costs after tax.

It is “good debt” because it is reasonable to expect that you will make a significant net gain over time from keeping the credit line, assuming you are investing effectively.

Ed

It is not paid off from the mortgage perspective, you owe money to the lender. However, from your perspective it is “paid off” as long as your assets (bought on borrowed money) exceed your liabilities (the amount you owe). In hypothetical case when the lender demands the immediate and full payment of the loan you can sell the assets and generate enough cash to cover it, probably leaving you with a profit as well. At least this is the way I see the investment loan for myself.

The strategy you are talking about is not the Smith Manoeuvre at all. It is just ordinary leverage using the dividend to pay the loan interest.

With the SM, you readvance the principal portion of each mortgage payment to invest and to capitalize the interest on the investment credit line.

Whether or not you get dividends as part of the investment return is one of many factors in the investment decision. In general, receiving dividends reduces the long term return of the Smith Manoeuvre because of the “tax bleed” of annual taxes on the investment income.

The long term total return of your investments is the critical factor, and having tax-efficient investments is a plus.

The answer to your question is that the total return of the stocks should be much more than just the dividend, so if you understand the risk and will invest for the long term (especially during the inevitable bear markets), then the profit should be far more than the interest on the credit line – especially after tax.

Ed