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Adding (non borrowed) Cash to a Leveraged Portfolio

As the installment portion of my mortgage is soon coming to an end, lately I’ve been thinking about my leveraged portfolio and how I’m going to utilize it going forward.  I’ve written about the various options available to leveraged investors once their mortgage is paid off, but I didn’t get into the investment plan going forward.

For me,  I will most likely keep the existing HELOC balance (and portfolio) but use the freed up cash flow to invest with instead of increasing the investment loan.  Perhaps it’s my conservative side coming out, but why leverage if cash is available to invest with?  I may, on occasion, dip into the HELOC balance to invest in opportunities that require large amounts of cash, such as an investment real estate transaction.

As that is my tentative plan, the question now is, how should I structure my accounts?

Ideally, to keep it simple (I already have too many investment accounts), I would like to add to my existing leveraged portfolio, but with new cash.  However, mingling regular cash with a leveraged investment loan may get messy with regards to the tax deductibility of the investment loan.  So I sought out a tax expert, Tax Guy with my concerns.  Here is what he came back with:

Co-mingling cash contributions to your leveraged investment account “may” affect the deductibility of interest. Provided you can track each cash contribution, the worst case scenario would be a proportional split of the interest.

Example:

Assume you have fully paid off the instalment portion and end up with a HELOC of $200,000 and a portfolio valued at $300,000. At the beginning of the year, you place an additional $10,000 of cash in the brokerage account. The account earns 7% for the year and has a FMV of $331,700 at the end of the year.

The interest you can deduct should be in proportion to the amount of the account you have funded with the loan or 90.4%.

Again his would be a worst case scenario (provided you can always track each dollar). Best case scenario would that the CRA would allow you to deduct the full interest from the HELOC although this would get messed up if you decide to take funds out of the account. Withdrawals would most definitely affect interest deductibility.

I would recommend you use a separate brokerage account for cash investments and keep it separate from your leveraged investments.

The idea of tracking every non-borrowed dollar deposited into the leveraged portfolio does not appeal to me, so I will have to resort to using an existing non leveraged, non-registered account or opening a brand new stock brokerage account.  If you’re a tax expert, I’d like to hear your take on this as well.  For those of you who are using the Smith Manoeuvre strategy, what are your plans once the installment portion of your mortgage is paid off?

Update: After many questions in the comments, Tax Guy revised his explanation:

Assume you have fully paid off the instalment portion and end up with a HELOC of $200,000 and a portfolio valued at $300,000. At the beginning of the year, you place an additional $10,000 of cash in the brokerage account. The account earns 7% for the year and has a FMV of $331,700 at the end of the year. At the end of the year, you take out the $10,000 and use it for a personal expense.

Prior to the withdrawal, the HELOC funded 97% of the account. This proportion would be preserved following the withdrawal but the same proportion may affect the amount of interest deducted. Thus only 97% of the HELOC interest would be deductible.

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FT About the author: FT 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.

{ 27 comments… add one }
  • Four Pillars November 2, 2009, 10:02 am

    I’m not sure I understand that answer.

    I was under the impression that “comingling” borrowed and non-borrowed money only applied to the loan itself.

    For example if you borrow from your HELOC and buy stocks and also borrow from the same HELOC to buy a car then CRA will have a problem with that (I phoned and clarified this).

    I don’t see why having an investment account with leveraged investment and non-leveraged investments would be a problem.

    For example if you have a business – you can borrow money to help out the business (and deduct the interest) and you can also put your own cash into that business as well. If you consider the business as an investment account then you are putting leveraged/non-leveraged $$ in the same account.

  • Tax Guy November 2, 2009, 10:03 am

    Thanks for the mention!

  • Four Pillars November 2, 2009, 11:04 am

    Ok, I thought about this some more on the way to work and I see now that you would need separate accounts (or track everything). One more account isn’t a big deal… :)

    I still don’t know how this applies to a business where you are obviously comingling assets.

  • Tax Guy November 2, 2009, 11:23 am

    @ Four Pillars

    In a personal investment account you can taint the loan or you can taint the account. You can taint the account by adding cash to the account and you taint the loan by using parts of it for other personal purposes.

    If the loan was used for investment into a business (corporation), there is probably no tainting of the account because the cash contribution would be from business operations and would still be deductible. However, if you use your HELOC to finance the business, you can taint the HELOC by using some of the proceeds for non-business or investment purposes.

  • Finance_Addict November 2, 2009, 12:28 pm

    I’m no tax expert. But I don’t think you need one here. Like you said keep it simple. I’m in a similar situation. I will keep the HELOC open and will continue to invest with it. I will then open a separate non-registered account that will be fed with my own free cash flow. I suppose the question is what types of investments will you make with both accounts? Conservative, long term in both? Shorter term trades with the HELOC? My thinking is that I will continue to invest in dividend paying stocks with the HELOC to be able to claim but maybe shorter term, large trades…not really sure. I think it may change your investment style in at least one of the accounts. As you found out I would not complicate things by combining your cash into the HELOC. I too see the light and your post has me thinking ahead about what to do next.

  • Nurseb911 November 2, 2009, 12:43 pm

    Good post FT. I’m just starting out with my HELOC and have a few years on the balance of my house until regular payments will cease. But its interesting to read how others are tackling these questions. Keep readers informed of how the process goes!

  • Observer November 2, 2009, 2:36 pm

    Tax Guy/MDJ – I don’t understand the issue with the co-mingling. I thought CRA cared about the use of the borrowed money. So if I borrow $300k and with clear paper trail I invest it, then (subject to the other conditions) the interest should be tax deductible. If I then add $100k cash to the same investment account and buy additional investments, what has changed to “taint” the original money?

    I could see there could be issues if I later turn around and withdraw 1/2 the total account value – in that case, what proportion of the loan interest stays deductible? However, as long as I don’t do that, why would the CRA claim I should only be deducting 3/4 of the interest? The paper trail of the borrowed money into the investments is untouched by other money having followed a different path later.

  • Elbyron November 2, 2009, 2:47 pm

    What’s important to the CRA is the traceability of the borrowed money. If I buy x shares of A with a loan, and later buy another x shares of A with the same brokerage account using cash, I have “tainted” in the sense that I have made it more difficult to trace the borrowed money. If I just left the account alone for a while and then went to sell it all, then I could probably treat half the proceeds as if it originated from the loan (provided I have a solid paper trail as proof). But if you’re buying and selling stocks frequently, it would become extremely difficult to keep track of what profits came from what source. That’s my view anyway – but I’m not a tax expert.

  • cannon_fodder November 2, 2009, 3:16 pm

    As we get closer to retiring our SM mortgage (it’s open so we have a lot of flexibility but certainly no more than 18 months) I’m more concerned with how the bank will treat the HELOC portion.

    For example, if our term is 4 years and we retire our mortgage in only 3 years, will the bank allow us to keep the HELOC intact with all of the same terms? Could they say we need to restructure the entire deal again with new adminstration fees and perhaps even a Prime + X% interest rate structure on the HELOC?

    Our plan is once our payments eliminate the mortgage portion, then those same payments will be steered towards the HELOC amount. For the ultimate in flexibility, we are trying to position our retirement to begin with no debt so that it makes it easier for us to leave the country if that is something we’d like to do. For my wife, she does not want any debt when she retires – it doesn’t matter to her that it may be financially better to have a deductible loan funding a retirement portfolio. She would sleep better at night and that is something you always need to take into account.

  • Tax Guy November 2, 2009, 3:21 pm

    As I re-read my response to FT, I realize why there is some confusion (and I am a little red-faced too)!

    There are two related issues: One with tainting the account and the other is tainting the loan.

    If you use a portion of the HELOC for anything other than investments, you “may” taint the deductibility of interest. For example, if you paid down a portion of the HELOC and bought a car, you would lose a portion of the interest expense as a deduction.

    You need to be able to trace the source of funds to the use of the funds. Often with a HELOC, people will use it for both deductible and non-deductible expenses. This should be avoided.

    When you contribute cash to an investment account, you do not taint the deductibility of interest on the HELOC. The full interest is still deductible.

    However, if you withdraw funds from the account, you can affect the deductibility of interest. For example, if you borrow to invest and then add personal cash to the account and then withdraw a portion in the future, the withdrawal will affect the amount of interest that can be deducted.

    The point I was trying to make in my response to FT was that keeping separate accounts is always easier than trying to track contributions and withdrawals from the account and principal payments and purchases wit the HELOC.

  • Sampson November 2, 2009, 5:46 pm

    I am very surprised and curious that it sound like the majority of those with existing HELOCs used to invest are planning to drop leveraged investing period.

    I certainly understand how it would be nice to be completely debt free (even if you have underlying investments of equivalent worth) – but now that you have greater assets (house paid off), why are you more likely to not want to leverage?

    Seems like most with HELOCs probably simply set them up to write off some of the interest, and not actually to produce greater returns.

  • cannon_fodder November 2, 2009, 6:04 pm

    Sampson,

    For me, the reason to eliminate leveraged investing by the time I retire is partly because it would be too stressful for my wife, and by association, myself. The second reason is that I reduce certain flexibility and control over my own affairs. In retirement I would need more stability (leveraged investing amplifies moves) and would not be in a favourable position to respond (e.g. go back to work).

    If I was starting this out when I was 25 and eliminated my mortgage at 40 then I would not be leaning towards eliminating the HELOC immediately.

  • cannon_fodder November 2, 2009, 6:14 pm

    Tax Guy,

    While we have your attention, please confirm that this does not affect any interest deductability:

    A non-registered portfolio completely funded by a HELOC which doesn’t fund anything else;
    A non-registered portfolio that consists of some dividend paying companies;
    You withdraw amounts no more than (and certainly could be less) than the dividend payouts;
    You funnel that to either: the mortgage portion of an SM product (perhaps then withdrawing the principal paydown from the HELOC to then go back into the non-reg portfolio); OR, you fund some other banking account for other purposes (pay down non-deductible debt, RRSP contributions, etc.).

    In all of the above, are there any red flags other than the typical ensuring that there are clear lines of money movement?

  • Four Pillars November 2, 2009, 6:19 pm

    You withdraw amounts no more than (and certainly could be less) than the dividend payouts;

    Any reinvested dividends are basically the same as new purchases. If you leave them in the same account then you will have to track them if you want to do any partial withdrawals later on.

    I always withdraw all my dividends from my leveraged account.

  • Observer November 2, 2009, 6:22 pm

    Tax Guy – thanks for the clarification. That matches my understanding as well.

    Sampson – we have just paid off the nondeductible part of our mortgage and are planning to keep our investment loan (an open variable mortgage with 40 years amortization – not quite a HELOC but close) going, just putting additional cash into investments as well. We are comfortable with our overall risk profile, therefore see no reason to change.

  • Tax Guy November 2, 2009, 6:30 pm

    @ cannon_fodder:

    The loan was used to purchase investments that earn income. You could withdraw the interest and dividends from the account without affecting the deductibility status of the HELOC. There would be no proportional decrease in interest deductibility.

  • Brendan November 2, 2009, 11:59 pm

    Tax guy, what about capital gains withdrawn from the leveraged account?

    I know that any ROC will screw up the deductibility , but I also understand that if you are taxed on it, you can take it out, be it interest, dividends, or capital gains. Your own capital is not taxable therefore you cannot take it out.

    Mutual funds also distribute capital gains and you are taxed on them. Surely you can take gains out of the leveraged account.

    I am still curious as to the draw down phase of a Smith manouevre. Seems complicated. Certain withdrawals must be paid down on the heloc, or used to service the interest.

    Is there anyone here actually retired, drawing from a leveraged portfolio?
    Ed happened to mention a couple of new strategies(in regards to a SM draw down?) in another post. I hope he will post soon.

  • Ms Save Money November 3, 2009, 10:48 pm

    I think reinvesting cash in any investment is fine.

  • Jared November 3, 2009, 11:14 pm

    @Four Pillars

    Your comment

    “Any reinvested dividends are basically the same as new purchases. If you leave them in the same account then you will have to track them if you want to do any partial withdrawals later on.

    I always withdraw all my dividends from my leveraged account.”

    Just looking for a bit of clarifcation here from you and others.

    This basically means that all dividends should always be taken out of a leveraged account to ensure that all money in the account remains 100% from the HELOC? What about the case where the dividend given was actual shares? What should be done then?

  • Briefcases November 4, 2009, 9:56 pm

    I have no idea what a leveraged portfolio is. I guess I really have a lot to learn before I start investing money. I’ll have to keep reading this blog to sharpen my financial knowledge.

  • Ed Rempel January 23, 2010, 3:34 am

    Hi Tax Guy,

    In general I agree with your article, but you can choose to keep the investment loan completely deductible under the “flexible approach”.

    If you add $10,000 of your own money to a leverage account and the investments grow $31,700, if you then withdraw the $10,000 under the flexible approach you can choose to consider that the $10,000 withdrawal is entirely related to the $10,000 contribution of your own money. Therefore, the entire $200,000 investment loan remains deductible.

    This would not apply if the investments are down. In that case, you would have to consider the withdrawal to be proportional.

    The critical issue is the ACB. Generally, if the ACB remains at or above the loan amount, then you can choose to have the entire loan remain deductible by choosing to consider the withdrawal amount to relate to the portion of the ACB that is above the loan.

    The ACB of investments generally only goes up if you add other money or have a taxable transaction (sell at a profit and reinvest or reinvest a dividend). A withdrawal after that can be deemed to relate to the extra cash you invested or to the reinvested income.

    There are some examples of this in IT-533. Do you agree that this flexible approach can be used in your second example?

    Ed

  • Ed Rempel January 23, 2010, 3:43 am

    Hi Four Pillars and Jared,

    You do not generally need to withdraw all your dividends (although it might help) and you don’t need to track additional contributions or dividends.

    For example, if you receive a $1,000 dividend and immediately withdraw it, your investment loan is fully deductible. If you reinvest that dividend and the investments remain flat or go up, you can later take out $1,000 and deem that to be the $1,000 from the dividend, so that your loan remains fully deductible.

    You track this with the ACB of your investments.

    The problem comes in if the investments are down. If the $100,000 investments are down to $90,000 market value and then you take that $1,000 out, then it must be proportional – $990 is considered to be the borrowed money and $10 is considered to be from your dividend.

    This is called the “flexible approach” and is explained in IT-533.

    Ed

  • Brendan January 23, 2010, 11:57 am

    Ed does this mean you must keep thing proportional only if dividends are reinvested?
    The way I read it is if you buy stock you can withdraw any dividends with no worries as you aren t actually disposing of the original investment.
    Reinvesting dividends will affect the ACB but taking the dividends as cash as they come doesnt.

  • Ed Rempel January 23, 2010, 11:50 pm

    Brendan,

    If you reinvest the dividends, it increases the ACB by that amount and you can usually withdraw that amount later with affecting the deductibility of your loan.

    The issue whether your ACB is up or down. If the investments go down and you do any transactions, your ACB falls below the original amount borrowed. If the ACB is down, then any withdrawal is proportional.

    However, if you reinvest dividends or do transactions when your investments are up, so that the ACB rises, you can withdraw the amount of the increased ACB without affecting the deductibility of your loan.

    Over time, your investments and ACB should go up, so normally, withdrawing some money later is not a problem.

    Does that answer your question, Brendan?

    Ed

  • FT FrugalTrader February 13, 2012, 11:38 am

    Not sure if you guys are following this thread, but I’ve come to the conclusion that if you have free cash laying around and want to contribute to the leveraged account, simply pay down the HELOC, the reborrow again for the portfolio.

  • Jared February 13, 2012, 8:49 pm

    Frugal,

    That was my thought as well that it would just be easiest to pay down the load and re-borrow the money to add in to the leveraged account. It should have the exact same effect and make the accounting clear.

  • DivMan August 17, 2013, 1:20 pm

    I’ve been trying to find an answer to my question without luck, so I will ask here. I’ve been doing the leveraged investing with dividend paying stocks. Inspired by MDJ.

    I borrowed $50000 from a HELOC and bought stock “x” with it. Over the years I continued to borrow from the HELOC and bought other stocks to a total of $100000 borrowed. The original investment (stock “x”) has since grown in value to $90000 and the total portfolio is say $150000. I want to sell stock “x” only and withdraw it for cash flow (to buy another house). How much of the HELOC do I have to pay back to keep the interest in the HELOC 100% tax deductible?

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