If you are frowning and thinking to yourself, "Of course my mortgage interest is tax-deductible!" then you are likely a visitor from the United States. If you are frowning and thinking to yourself, "Of course my mortgage interest isn't tax-deductible!" then you are probably a Canadian. Our neighbours to the south have been enjoying a tax break on their mortgage interest for some time now. Although, as a Canadian, your home's mortgage interest is not normally tax-deductible, there is a technique that can make all or part of your mortgage interest expenses tax free.
Back when I first covered assets and liabilities, I warned against borrowing money to buy assets that quickly lose their value, such as fancy TVs and electronics. If you are going to borrow money, you should use that money to buy an asset that will appreciate in value over time, such as stocks or mutual funds.
One of the main reasons borrowing for the purpose of investing is so attractive, is the tax benefit. When you borrow money to invest, the interest you pay on that loan can be deducted from your income at tax time. So if you pay $1000 in interest on a loan used to purchase investments, you effectively reduce your taxable income by $1000.
One noteworthy exception to this is when you take out a mortgage to invest in a home that will be your principal place of residence. In this case, interest you pay on your mortgage is not tax-deductible. But it can be ...
If you've already got a decent sized investment portfolio, you can make all or part of your mortgage interest tax-deductible using what is called an asset swap. Here is an illustration showing how it is done:
So basically, you sell your investments to buy a house, then you borrow against your house to buy back your investments. You've swapped one asset for another and ended up right back where you started. Only now, you've given yourself a big tax break!
This doesn't have to be an all or nothing strategy though. If you don't have a big enough investment nest egg to buy a house completely, you can do a partial asset swap which will make a portion of your mortgage interest tax-deductible instead of the whole thing. Here's an example:
So now you have a $200,000 mortgage to pay off, except now, 25% of your mortgage interest payment ( $50,000 / $200,000 = 0.25 ) is tax-deductible! At the end of each year your mortgage provider will send you a statement showing how much interest you've paid on your mortgage for the year. You'll take that amount and multiply it by 25% to figure out how much to claim on your taxes.
Asset swapping is a bit of a gray area in the tax laws so there are some other things you might want to keep in mind. Here are a few:
As a result of some of these gray areas, you should make sure you keep good records of all the transactions involved in the asset swap. That way, if you are ever audited, you'll be able to show exactly what you did, and you'll have all the paper work to prove it.
If you are comfortable with the level of risk associated with asset swapping then this might be a great way to make a very common, and often large, expense tax-deductible. I would consider asset swapping an advanced investing technique, so just be sure you fully understand what you're getting into and that it is appropriate for your financial situation.