In contrast to the United States, Canada has a unique tax treatment for homeownership. Most notably, homeowners cannot deduct mortgage interest on their primary residence from their taxes. On the flip side, the capital gains realized from the sale of the home remain tax-free.
There exists a strategy for the savvy Canadian homeowner to possibly make the mortgage interest effectively tax-deductible. This method involves leveraging equity into an income-generating portfolio, accelerating mortgage repayment, and boosting cash flow via tax savings. The result? Simultaneous growth in net worth and cash flow.
A chunk of every mortgage payment is allocated towards interest, and the rest chips away at the principal amount. This repayment of the principal boosts the home’s equity, which can be borrowed against at rates often lower than those on an unsecured loan.
Here’s where the tax benefits come in. If homeowners use the funds borrowed against their equity to invest in income-producing assets, the interest on the equity loan can be reported as a tax-deductible expense. The strategy here is to continually borrow back the principal component of each mortgage repayment, to invest it under the Canadian tax code.
This method keeps the total debt constant, as the principal is continually re-borrowed. However, a growing portion evolves into tax-deductible (or ‘good’) debt, reducing the non-deductible (‘bad’) debt.
To get a better understanding of this cunning strategy let’s consider a hypothetical example. Couple A purchases a home worth $200,000 with a $100,000 mortgage over ten years at 6% interest. They make monthly payments of $1,106. Once the mortgage is settled, they invest the monthly payment amount for the next five years, earning 8% annually. After 15 years, they have a home and an investment portfolio worth $81,156.
Now, let’s explore Couple B, who buy a similarly priced home under the same mortgage terms. Every month, they re-borrow the principal and invest it. They also use their annual tax return from the tax-deductible interest to pay down their mortgage principal. After nearly 10 years, the entire mortgage shifts to good debt, generating an annual tax refund of $2,340 at a marginal tax rate of 39%. In 15 years, they own their home and boast a portfolio worth $138,941, reflecting a 71% increase.
However, this timely strategy to hike net worth while shredding liabilities is not for everyone. Those unfamiliar with the nuances could face risk. Borrowing against your home can entail mental strains. Plus, this approach could backfire if the investments do not yield expected returns.
It’s critical to have a conversation with a financial advisor if you are considering attempting this strategy. Experienced professionals can help tailor it to your personal financial circumstances.
Under this strategy, $612 of the monthly mortgage payment made by Couple B goes to principal reduction, with the remaining $494 servicing interest. That $612 then makes its way back out as an investment. The total debt remains at $100,000, but the tax-deductible portion increases with each payment cycle.
This cunning approach can be taken even further. The element of tax-deductible interest, in turn, results in an annual tax refund, which can be used to further pay down the mortgage. This added payment could be wholly re-borrowed and invested in the same income-producing assets.
In the end, the matched mortgage figure of $100,000 becomes entirely tax-deductible. By now, the tax refunds coming in can also be invested, consequently accelerating the growth of the investment portfolio.
As per the Bank of Canada, a five-year conventional mortgage carried an average interest rate of 6.49% as of July 19, 2023. Mortgage interest is fully tax-deductible in Canada, given that the property is employed to earn investment income throughout the year.
In the U.S., homeowners can deduct a slice of their principal residence's interest from their taxable income. However, for Canadian homeowners, an option is to use the equity in their primary residence to procure a mortgage on an investment property. Interest on income-driven property mortgage is fully tax deductible, lowering tax liability while saving money.
As with any financial venture, considering the benefits and risks is key. If you are intrigued by this approach, talk to a financial advisor before making any firm decisions.