How to make your Canadian Mortgage Interest Tax Deductible

November 7, 2018 | Posted by: Calum Ross

Here in Canada, we don’t get to write off home mortgage interest on our personal residences they do in the United States without formal planning. Many Canadians have to pay every dollar of interest with after-tax dollars. The name of the game here is tax savings and wealth creation through strategic conservative leverage wealth strategy.

But there is a way around that for many Canadian homeowners that was formerly called the Smith Manoeuvre. This popular tax planning tactic is named by Fraser Smith, a well-known Canadian author of a popular personal finance book, The Smith Manoeuvre. While the book is somewhat antiquated on the mortgage side now – much of the core fundamentals still hold true. In the interest of full disclosure, I met with the late Fraser Smith in 2003 to discuss how to support Canadians at a broader level with this strategy.

Here’s how it works

Canada does not allow you to deduct personal mortgage interest. But it does allow you to deduct interest on loans you make for the purposes of investment, as long as you do it within a non-registered account and meet CRA guidelines for deductibility which can be found on CRA’s website in a simplified version here:

https://www.canada.ca/en/revenue-agency/services/tax/technical-information/income-tax/income-tax-folios-index/series-3-property-investments-savings-plans/series-3-property-investments-savings-plan-folio-6-interest/income-tax-folio-s3-f6-c1-interest-deductibility.html

But how do you turn your personal home loan into an investment loan? Well, you can’t do it all at once. But you can do it a little at a time, using a tool called a “re-advanceable mortgage.”

These mortgages are essentially revolving credit facilities. You get approved for a certain amount, and take out the mortgage to buy your home. But as you pay down the principal on the debt, that line of credit doesn’t go away. It remains open. The lender knows they still have the home to secure the debt, so they’re happy to keep lending to you and collecting their interest, thus keeping a performing loan on their books. The key here is to keep tax deductible borrowing separate and keep investments loans and the investments compliant with the Income Tax Act - which is arguably one of the most complicated and boring documents known to human kind. Having said that – it is immaculately and intelligently constructed, and it is the play book that we must all follow.

So as you pay down your principal, your home equity line of credit gradually increases. You can borrow it back – a little more each month – and use the proceeds for any purpose you like.

But a suggested use would be: Take the additional proceeds and invest them in tax-favored Canadian dividend-paying stocks.

Yes, you’re still paying interest on your home mortgage. But you get a tax deduction on the interest used to own investments, as opposed to your personal residence. Meanwhile, you start getting a regular cash flow from the dividends – on a favorable tax basis (consult a tax professional).

To maximize the long-term wealth-building effects of the strategy, you then take those tax-favored dividends from Canadian stocks and use them to make extra payments on your mortgage. Every dollar you pay against your mortgage principal reduces your remaining non-tax-deductible borrowing – and frees up more room in that home equity line of credit to buy more Canadian dividend-paying stocks, and increase your tax-advantaged cash flow.

There are a number of possible variations, but the diagram below illustrates how the cycle works, using a re-advanceable mortgage and Canadian dividend-paying stocks or funds:

The re-advanceable mortgage makes it easy and convenient: You don’t have to reapply for credit every month. You don’t have to get a re-appraisal of your home’s value, or subject yourself to any additional personal income or credit underwriting. Instead, the line of credit in a re-advanceable mortgage expands automatically as you pay down the mortgage. Just contact the lender and request the funds. As soon as you receive them, you can use the money to make the investments.

And because it’s a mortgage, ultimately secured by your home, the interest rate and terms are typically more favorable than they are for unsecured loans, such as credit card cash advances and personal loans.

The net income on your investments should be more than enough to cover your interest payments on the mortgage, and as you repeat the cycle, you should be able to gradually accelerate paying off your original mortgage and increase your cash flow.

For many investors, it’s a great way to begin saving for your retirement immediately without crimping your cash flow beyond what you’re already paying on your mortgage. Of course, you can always invest more and the key to any meaningful wealth strategy is save early and save often.

Here’s the intended result:

  • Your initial mortgage with the taxable interest should be paid off much sooner than it would have been otherwise.
  • You will have a sizeable portfolio of Canadian dividend-paying stocks, generating a steady stream tax-advantaged income that should be more than enough to pay the continuing interest on the loan.
  • You may actually get a tax refund, which you can use to pay down your non-tax-deductible mortgage on your home, further accelerating the process.
  • All your interest that was taxable when you first took out the mortgage is now tax deductible.
  • Your home is paid for – assuming you use a wealth manager or portfolio manager you should be able to sell enough assets to pay off the loan immediately, if you choose to. But if the dividends are more than covering your interest, you may not want to pay off the loan at all but hang on to your assets so you can benefit from capital appreciation and any dividend increases over time.  Once you can pay off your mortgage at any time – the mortgage is a leverage wealth tool and is no longer stressful.
  • The tax-advantaged dividends will still be there to supplement your income in retirement.
  • You may also benefit from increasing dividends and capital appreciation reflected in stock prices over time.

The strategy has historically been very effective, because long-term returns on Canadian stocks have been much greater than typical borrowing rates on home mortgages – especially on an after-tax basis.  

A few caveats:

  • Dividends, by their nature, are not guaranteed. They rely on the future profitability of the issuing corporation.
  • Their stocks can and do lose value.
  • They may reduce their dividends or stop paying them altogether, either because they have no profits or they are choosing to reinvest them in the company.
  • They are subject to all the risks of the Canadian economy. If the Canadian economy should suffer, it could affect the value of most Canadian stocks.
  • This is a leveraged strategy. You should understand the advantages and disadvantages of leverage, and how it doesn’t just magnify gains, but magnifies losses, as well.
  • You must be financially and psychologically be able to keep up your mortgage payments even in the event of a major bear market in Canadian stocks.
  • Keep careful financial records
  • You cannot keep your investments in a TFSA or RRSP and make your borrowing tax deductible.
  • Don’t co-mingle your deductible and non-deductible assets in the same account.
  • Don’t use the process to buy anything other than investments. If you use the funds for personal purposes, you could cause record keeping problems and find yourself with an unwanted tax bill.
  • Never execute a tax strategy without consulting a tax accountant or a tax lawyer (EVER).
  • I would STRONGLY recommend you work with an experienced portfolio manager (see IIROC or Canadian Securities Institute for details (https://www.csi.ca/student/en_ca/licensing/index.xhtml)

The strategy works best for people with long time horizons – ideally 10 years or longer and is mostly applicable for those in the middle and top tax brackets. It is not suitable for those with shorter time horizons who cannot ride out a significant stock market downturn.

Also, don’t let the tax tail wag the investment dog. The main benefit of the strategy is to accumulate assets. The tax benefits should be a secondary concern, and you should not take on more risk than you can handle just for the tax benefit.

There are several different variations on the strategy designed to increase returns, though some of them require more work on your part or may involve taking on more risk.

You should only employ on the Smith Manoeuvre strategy if you have a long-time horizon, understand the risks, and you’re willing to ride out short-term fluctuations in the stock market.

You should also only use this strategy with the advice of a qualified investment or tax professional with specific knowledge of the rules affecting tax deductibility and borrowing to invest. I would never recommend this strategy for anyone who does not have a Portfolio Manager managing their investments, a mortgage advisor who understands the strategy, and a full qualified tax accountant.

CRA supports long term investment in the economy and is our partner in keeping Canada financially viable. Don’t get advice on this unless the person is retained to work with you and has the formal qualifications. The rules on this are complex but highly profitable when done right. If you are a client of mine, I would be happy to put you in touch with a full team to execute this.

 *This article is intended for education purposes. Never execute any tax-deductible investment strategy without the guidance of a team of trained specialists.

Recommended team:

1)      Portfolio Manager as per governing legislation;
2)      Tax accountant or Tax Lawyer;
3)      Mortgage professional with financial credentials with expertise on effective use of collateral charge mortgages and knowledge of borrowing to invest.

Our team has designed dedicated account managers at both Scotia Bank and Manulife to help assist clients with this strategy. They are well versed in the paperwork and product structure to fulfill this strategy. Please note that I only recommend the account managers I have personally worked with or who have served my own clients. Both lenders have handled over $100 million dollars’ worth of my own client tax deductible mortgage strategies successfully. I highly suggest you don’t accept any substitutes.

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