As I have been considering implementing The Smith Manoeuvre, I have been doing some research on the tax benefits and how to make sure that all interest payments stay deductible. I came across some important taxation points that I thought I would share with you.
Is the investment loan tax deductible?
Before I start with the details, make sure that your investment loan is, in fact, an investment loan that is tax deductible. If you get a loan to invest in a tax-sheltered account, like an RRSP, TFSA, and/or an RESP, then the interest is not tax deductible.
Also, tax deductibility of an investment loan depends on if you use the proceeds to generate business/investment income. You cannot use a HELOC secured against your rental property on personal expenses and still claim the interest as a tax deduction.
Calculate your interest deductible:
- To determine the tax return of the interest paid on your investment loan, multiply the total interest paid during the year by your marginal tax rate.
- For example: if you paid $1,000 in interest for the year and you are in the 40% marginal tax bracket, you will receive $400 back from the government.
- Canada Customs and Revenue Agency (CCRA) expects that if you use borrowed money to invest that you will receive some sort of income from your investments. The “income” includes interest, dividends, rent, and royalties. Even if a stock that you purchase does NOT currently pay dividends, as long as they have a reasonable “expectation” of future dividend payments, then it “should” remain deductible.
- Although CRA only expects income from your investment portfolio, in 2003, the finance department declared that in order for investment loans to remain deductible, the interest/dividends must produce a profit. That is, the dividends must EXCEED the interest that you are paying on the loan. I know, the finance department and the CRA are on different pages. According to Tim Cestnick, the CRA will generally ignore the finance department rules and accept the tax deduction as long as it produces income but check with your tax professional for the latest rules.
Keep your interest deductible!
- Once you use a loan/line of credit to invest, do NOT withdraw from it unless it is from dividends/interest that the investment produces.
- For example, if you use a $10,000 line of credit to invest, achieve a $5,000 capital gain, and withdraw $5,000 to spend on a vacation. How much of your loan balance is still deductible? $10,000? Nope! According to Tim Cestnick, since you withdrew 1/3 from your investment loan, only 2/3 of your remaining loan is tax deductible.
- This includes Return Of Capital funds/income trusts also! Technically, as you receive ROC distributions, it will decrease the tax deductibility of the investment loan. This can be avoided by using the ROC to pay down the investment loan, then re-investing if desired. Technically, this “should” be the same as simply leaving the ROC distributions in the investment account (confirm with your accountant).
- If you gain $300 (or any amount) in dividends though, you can withdraw $300 and spend it as you please. If you’re using an investment loan to perform the “Smith Manoeuvre“, I would suggest to use the dividends to pay down the non-deductible mortgage to further accelerate the conversion to deductible/good debt.
- Make sure your investment loan produces income of some sort.
- If you are going to withdraw from your investment loan to spend, make sure you only withdraw an amount equal or less than the dividends/interest produced in the account.
- ROC distributions are undesirable for leveraged investment accounts as they decrease the tax deductibility of the investment loan. There are ways around this, but it can turn out to be an accounting/paper trail nightmare.