One of the largest expenses we have tends to be the mortgage on our home. Following traditional rules, we are limited to deducting at best a small percentage of the interest where we use a home office for business purposes. However, using non-traditional planning, we are able to deduct potentially 100% of the interest costs. In other words, we can make “bad” interest “good”.
Your tax savings will vary based on where you live in Canada, your income level and the amount of interest you pay. As a quick example though, with a mortgage of $200,000 at 4.5%, your tax savings could be approximately $3,000 per year. While this may not by itself create financial freedom, imagine receiving these savings year after year – with minimal effort required. Imagine the impact of a higher interest rate or larger mortgage.
A popular nick-name for describing some of the possible techniques is the “Smith Manouevre” coined by Frasor Smith. A variety of versions of the plan exist, and vary in aggressiveness and implementation to suit your needs and comfort. With a Supreme Court decision related in part to questions surrounding the appropriateness of interest deduction plans, tax advisors have largely been given the green light to help clients restructure their affairs in an optimal fashion.
In its simplest form, these interest deductibility techniques allow homeowners the ability to convert the non-deductible portion of the interest on their mortgage to fully deductible over a period of time. This period of time is typically several years, however, your financial situation and aggressiveness may dramatically decrease this time.
A variety of mortgage products provide the ability to divide your mortgage into at least two segments which allows you to track the interest expense on these segments separately. Your total mortgage will typically be set at 75% or 80% of the value of your home. If you are permitted a total mortgage of $200,000 on your home, you may start with the “bad” portion (non-deductible) of the mortgage at this $200,000 and the “good” portion (deductible) of the mortgage at zero. As you make payments on the mortgage, your principal on the bad mortgage will decrease leaving you additional room to borrow on the good debt. In other words, your total mortgage may still be $200,000, however it is divided between good and bad debt.
So, what do you do with this good debt? You invest. Traditionally this was thought of as an excellent vehicle to acquire mutual funds and similar investments. However, this may be a great opportunity for you to go beyond and invest in YOUR business.
You may be able to shorten the conversion time of your bad debt where for example you have non-registered financial assets that can be sold and the proceeds used to pay down some bad debt. Tax refunds, inheritances, unexpected sources of funds, extra mortgage payments are further ways of speeding up the conversion.
While restructuring must be done properly, your efforts will be rewarded. Talk to your tax, mortgage and investment advisors to determine whether such a plan can work for you and you are comfortable with the full implications. Also work closely with your mortgage advisor as you pay close attention to the features of the mortgage product that you use to ensure you have the required flexibility to accomplish your goals. There are significant differences between the products beyond the interest rates which command your attention.
This article is brief in nature and omits many important details that may dramatically change how financial plans may affect your particular situation. This should not be considered tax, investment, business or similar advice. Before implementing any plans, always discuss in full with your tax advisor and other relevant advisors.
George E. Dube, CPA, CA