Proper total wealth planning advice involves managing debt, as well as investments. For this column, we’re addressing two common types of debt – mortgages and lines of credit – and we will illustrate four associated common debt mistakes and our recommendations.
By structuring your debt appropriately, some investors may be able to take more tax advantages from the interest costs they are paying.
Scenario 1: Mr. Wood – Splitting the mortgage
Mr. Wood owns a 2,000-square-foot home. He lives in the top 1,000 square feet and rents the other level. He has one mortgage of $340,000 at four per cent that is coming up for renewal. In the past, Mr. Wood made extra payments when cash flow permitted. For tax purposes, he would deduct one half of the total interest paid (not the principal portion) on the one mortgage.
Our recommendation: Mr. Wood should talk to his mortgage broker about splitting the mortgage into two distinct portions. He could name the portion he lives in as “Upper Level” and the other rental portion as “Lower Level.”
By separating these two portions, he could have some flexibility as to the interest rate he sets for each, and how he makes payments. He may want the lowest mortgage rate possible for the Upper Level as this portion is not deductible, whereas the Lower Level could have a higher interest rate as this portion would be fully deductible.
Financial institutions shouldn’t have a problem with this structure, especially if you communicate the intention to apply extra payments to the lowest mortgage rate loan. Any extra principal payments should be applied to the Upper Level mortgage only. If Mr. Wood does not separate these two portions, then principal repayments would be applied equally to both, reducing current and future interest expense deductions.
Scenario 2: Dr. Wilson – Establish separate lines of credit
Dr. Wilson has a professional dental practice with significant real estate holdings. He also enjoys travelling.
A few years back, Dr. Wilson established a line of credit that was used for a mixture of business and personal purposes. Initially, he took the line of credit out to assist him with a couple of his real estate holdings, especially the one that required a new roof. Since that time, he has used the line of credit to renovate the office, fund the family vacation to Italy, and provide an interest only loan to his son to purchase a vehicle.
Our recommendation: We suggested a meeting with Dr. Wilson’s accountant and banker to separate the one line of credit into three lines of credit as follows: business, personal, and son’s loan. Once this was established, we recommended Dr. Wilson focus on paying off the principal relating to the personal line of credit first. The reason for this is that interest costs relating to this personal portion are ineligible and not tax deductible.
Dr. Wilson should make interest only payments on the business line of credit until the personal line of credit is fully paid off. We also recommended isolating the amount relating to the son’s loan so it can be tracked. Separating lines of credit will make it easier come tax time for the business. If Dr. Wilson had not separated the lines of credit, then principal repayments would likely be applied proportionately against the eligible (corporate) and ineligible (personal) portions. It would also be a continuous accounting headache that he would likely have been charged extra to sort out each year.
Scenario 3: Mr. Muller – Converting residential debt so it is tax deductible
Mr. Muller came to see us recently for a second opinion. We noted that he had $150,000 in non-registered investments and $350,000 in his RRSP. We also noted in the financial information that he had a mortgage of $280,000 at four per cent. The problem we saw with this situation is that he had no interest deductions (carrying charge) on his income tax return. In order to convert the interest costs so they were eligible, we phoned his accountant and banker to discuss the situation.
Our recommendation: We mapped out a plan that would take approximately two weeks and three main steps. The first was to sell all of Mr. Muller’s investments in his non-registered account. We opened fee-based investment accounts for Mr. Muller, so no trading commissions would apply. We estimated the net capital gain from selling his investments was approximately $25,000. We noted that he had net capital losses of other years that could fully offset these gains.
The second step was to transfer the $150,000 from his non-registered investment account to his bank to repay part of his $280,000 mortgage, while simultaneously taking out a new separate mortgage for $150,000. In order to facilitate the above, the terms of both loans were extended to the nearest year (adding approximately five months to his existing term).
The third step involved the bank transferring the funds from the new separate mortgage into Mr. Muller’s non-registered investment account for the purpose of investing. Mr. Muller could repurchase the stocks that were sold for a gain with no tax consequences. Our recommendations focused on purchasing dividend paying common shares that he did not previously own. As a result of the above steps, Mr. Muller can now deduct the annual interest cost on the $150,000 debt linked to the investments and focus on paying off the non-deductible portion of the debt, which was at $130,000 ($280,000 - $150,000).
Scenario 4: Mrs. Clark – Transferring debt so it is tax deductible
Mrs. Clark was widowed last year. She decided to move to Vancouver Island from Alberta. She had some money in the bank which she used as a down payment on her new principal residence on Vancouver Island, and took out a mortgage to finance the remaining $320,000 at 1.8 per cent. When we were gathering initial “know your client” information from Mrs. Clark, we noted that she still owns her previous principal residence in Alberta. She decided to rent this property out and generate some rental income. In talking to Mrs. Clark, she mentioned that she has no mortgage on the Alberta property valued at $740,000.
Our recommendation: In talking to Mrs. Clark, we explained to her that the way the debt has been structured, she cannot deduct the interest costs on the mortgage on her principal residence. Our recommendation to her was to finance the Alberta property, and use the proceeds to pay off her mortgage on her principal residence. We discussed the options with the bank, and her accountant, and encouraged her to arrange a meeting with them to change the structure.
This simple restructuring of the debt would result in Mrs. Clark being able to write off approximately $5,760 ($320,000 x 1.8 per cent) in interest costs against her rental income.
As illustrated through the above examples, there may be tax efficiencies to be gained by restructuring your debt. If you currently are paying ineligible interest, it might be worth your while to speak to your accountant, banker and Portfolio Manager.
Kevin Greenard CPA CA FMA CFP CIM is a Portfolio Manager and Director, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timescolonist.com. Call 250-389-2138, email email@example.com, or visit greenardgroup.com.