Is Your Mortgage Interest Tax-Deductible?
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.
Borrowing Money To Invest
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 ...
The Asset Swap
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:
Asset Swap: At the end of the day, you have a mortgage and an investment portfolio, only now, your mortgage interest is tax-deductible.
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!
The Partial Asset Swap
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:
- You are buying a house worth $200,000.
- You have $50,000 in investment assets.
- You make a $50,000 down payment on the house using your investment assets, leaving you with $150,000 left to pay.
- You take out a mortgage for the full value of your house, $200,000.
- Using the $200,000 mortgage money, you pay the $150,000 you still owe for the house, leaving you with $50,000 cash.
- You purchase $50,000 worth of investments.
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.
Other Considerations
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:
- If you incur a capital loss when you sell your investments, you can't claim that capital loss if you re-purchase the exact same investment within 30 days. So you'll want to wait 30 days before getting back into the same investment.
- Regardless of whether you had a capital loss or not, some investment professionals recommend waiting 30 days before re-purchasing the exact same investments when asset swapping. This helps make it clear that you've done two separate actions: selling investments to buy a house, then borrowing against the house to invest.
- There is also some debate about what types of investments are eligible for this type of tax-deduction. In Revenue Canada's income tax guide there is a line the reads "... if the only earnings your investment can produce are capital gains, you cannot claim the interest you paid." Some people insist, however, that even if your investments don't pay interest or dividends, the interest can still be deducted. If you want to stay out of this gray area, buy an investment that pays a dividend or some interest income so you know you are in the clear.
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.
All Said And Done
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.
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Comments
Sounds risky! Not only do
Sounds risky! Not only do you have the risk of running afoul of the law, you also face the question of where real estate is going.
That said, it's vaguely similar to a strategy my tax lawyer came up with: I'm taking money from my IRA, which in the U.S. is taxable at my ordinary income tax rate (about 28%--I'm over 59 1/2 years old) and using it to make mortgage payments on an investment house. Because I'm moving it from an investment to an investment, the tax on it is a wash and it does not push me into the AMT bracket.
When I go to sell the house, I will have to pay capital gains tax, which is significantly lower (for the time being) than ordinary income tax. No doubt after the Democrats get in, they will raise capital gains taxes, since something does have to be done to right our foundering economy. But if they don't raise it to 28%, I'm still ahead.
Well, you always have the
Well, you always have the risk of sliding real estate prices, even if you go with a conventional mortgage. So you aren't risking anything more on that front by using an asset swap.
The risk of getting a negative ruling from the tax collector is a real risk, but if you wait the 30 days (or longer) you should be in the clear. You'll also want to make sure you've got all the required documentation to show what you did in case you do get audited.
As always, do your own research to make sure you're not getting into something that isn't appropriate for your personal situation.
how/where do you file this
how/where do you file this tax-deductible? Line#?
Good question! You'll
Good question! You'll include this amount as a "Carrying Charge & Interest Expense" on line 221 of your tax return. Here is a description on the Canada Revenue Agency website.
Can you buy a cottage using
Can you buy a cottage using a mortgage and claim the interest back. The cottage would not be your primary residence.
Yep. Actually, you buy a
Yep. Actually, you buy a cottage using your investments and then you mortgage your cottage in order to get some money to invest. It doesn't really matter what type of property is involved as long as the money is clearly used for investing.
I am always all ears
I am always all ears whenever I hear about my financial possibilities and this little "tutorial" you provided here will help me reorganize my priorities. I should pay more attention to tax deduction and profits because a smart move can save me good money. Accessing an e file to check my current tax status would be a good starting point.
will us canadians ever enjoy
will us canadians ever enjoy the tax breaks on mortgages the USA citazens get?
What are the risks? Other
What are the risks?
Other than the inherent risk in the value of your securities dropping, what are some of the other potential drawbacks?
I do not have a mortgage. I
I do not have a mortgage. I bought land using a home equity secured line of credit. Would the mortage swap still work under this scenario?
@AnonymousRisk: What are the
@AnonymousRisk: What are the other risks? Well, the biggest and most significant risk is that you value of your investments will decrease in value. Let's say you borrow $50,000 against your home and buy $50,000 worth of dividend paying stocks. If the value of those stocks drops to $0 (i.e. the company goes bankrupt) then you own $0 in stocks but you still own $50,000 on your home. As long as the investments you purchase maintain their value, then you can always sell them, pay your debts and be back where you started.
The other risk is a cash flow risk. This would happen if you didn't have enough income coming in to cover the interest expenses on your loan. In the example above if your interest rate on your loan was 5% per year, then you'd need to have enough income coming in to pay the yearly interest expense of $2,500.
However, as long as you investment retain their value, you'll be able to sell them and repay your loan if anything else should come up.
@AnonymousLand: If you bought land with your home equity, then the only way you can claim the interest on your home equity loan is if you have a "reasonable expectation" of getting an income from your land purchase. So, for example, if your land is right next to a major highway and you are selling billboard advertising space to get some income, then you might be able to justify deducting your interest expenses. If your land is just sitting vacant waiting for you to build a cottage on it or something, then you likely won't be able to claim the interest as an expense on your taxes. You need to be able to generate some sort of income from your investment.
Great post and I'm really
Great post and I'm really glad I finally found some sound CANADIAN advice on the internet. Well done! I have a follow up question I am hoping you can help me with. Here's my situation:
I have a $200,000 mortgage on principal residence.
I have a $45,000 line of credit (against the principal residence) on a U.S. vacation property.
The bank won't acknowledge the U.S. property. So it's just a $200,000 mortgage on my house, and a $45,000 home equity line of credit as far as the bank is concerned.
I sell the house. The mortgage and the attached home equity line of credit has to be paid off according to the bank.
I get a new mortgage for $245,000 on my new and better principal residence.
The bank will not give me a $45,000 line of credit because I am "maxed out" with regards to debt ratios. So I still own my home and the U.S. property is owned "outright" (I don't own anything on it).
I know that I could ask for a $45,000 line of credit (probably unsecured) and then use that money to pay down the residential mortgage. That line of credit would be unsecured; the interest rate would probably be higher. But can I avoid the legal fees and interest differential of opening up an unsecured line of credit and just "dedicate" $45,000 of my residential mortgage to a vacation property?
In other words, can I just split one mortgage on paper for tax purposes or do I need to physically establish two separate lines of credit / mortgages?
Many thanks!
@Wiebes: Well from my
@Wiebes: Well from my experience, CCRA (Canada Customs & Revenue Agency) would want to see an actual separate mortgage or line of credit. If you ever got audited, I expect that they would ask to see the paperwork and if you didn't have any then they would disallow your claim and ask you to repay any deductions you've claimed. Of course, you might get a different (and more accurate) answer by consulting a tax lawyer or accountant since they would be able to tell you for sure. Good luck!
I have not found any
I have not found any evidence anywhere to contradict what you have said. I agree, I think I need to establish a separate line. Good advice, and I will take it, many thanks!
Using your example: You are
Using your example:
You are buying a house worth $200,000.
You have $50,000 in investment assets.
You make a $50,000 down payment on the house using your investment assets, leaving you with $150,000 left to pay.
You take out a mortgage for the full value of your house, $200,000.
Using the $200,000 mortgage money, you pay the $150,000 you still owe for the house, leaving you with $50,000 cash.
You purchase $50,000 worth of investments.
This would leave the investor with one mortgage of $200,000 and assets of $50,000 in "investments" and $200,000 worth of house. Wouldn't this scenario be exactly the same as I described above? The $200,000 mortgage would not be split out, it would just be all-included. In this scenario, do you just take the mortgage amount and write off 25% of it?
What I have found is that
What I have found is that even if it is legitimate CRA auditors take a dim view of people who aggressively use legitimate tax laws. It is bullying, harassment. If somewhere else in your financial activities or your friends' or business associates' financial activities they find something they do not like they will pounce on your mortgage deduction and make your life miserable, even if you are able to come up with satisfactory documentation. In my case I was able to preserve about half of the deduction, after appeals. I did things in a way that was different from described, to make the mortgage interest a deductible expense by my company. I had my house mortgage jointly in my name and that of my consulting company, the consulting company made the payments, but the consulting company used the proceeds from the mortgage loan to pay my shareholder and other loans to the company. About half of these loans to the company had well documented terms and paid interest, the other half were more typical shareholder loans that did not have formal terms. CRA claimed that my company did not use the proceeds of the mortgage loan to earn income, therefore initially disallowed 100%. Only after showing, after much effort, that half the proceeds were used by the company to pay down debt they had a history of paying interest on did they allow the company to take 50% of the interest as a deduction. It was a horrible experience, I had to go back almost 30 years to original loans that had been replaced by other loans multiple times. It was not worth the aggravation and legal fees. CRA knows this. They abide by the "Susan Nelles" principle: if you (or associates) are using advanced tax saving methods you probably are cheating someplace so throw as much mud on the wall as possible to see what sticks.
A few common mistakes people
A few common mistakes people make when trying to make their mortgage tax efficent.
They buy stocks they don't know.
They buy stocks which distirbutes income or dividends, which means taxes which lowers the real return.
They do their own taxes or have someone who does their taxes and does not know what they are doing.
No risk management (insurance) or not enough.
cheers,
Brian
awsome topic, just
awsome topic, just bookmarked your article for future referrence
"If you incur a capital loss
"If you incur a capital loss when you sell your investments, you can't claim that capital loss if you re-purchase the exact same investment within 30 days. So you'll want to wait 30 days before getting back into the same investment."
.......Just to be clear, it's that you can't claim the loss IMMEDIATELY, you'll have to wait until later (after you've sold again and not rebought within 30 days). The capital loss isn't eliminated, just carried forward. I'm clearing this up because comments, as you've stated, I've heard a number of times, and confused me into thinking the "initial" capital loss would be lost/unclaimable for good.
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