Creating a Tax-Deductible Canadian Mortgage

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Creating a Tax-Deductible Canadian Mortgage

The tax code in Canada is considerably different from the one in the United States. Notably, a mortgage on a primary residential house does not qualify for a tax deduction. However, when selling the house, all capital gains are tax-free.

The interest on mortgages may, however, be successfully deducted in Canada.

Key Takeaways

  • The tax laws for homeowners in Canada are substantially different from those in the United States; for example, mortgage interest on a primary private dwelling is not tax deductible.
  • But there is a method for Canadians to deduct mortgage interest efficiently.
  • Every time a homeowner in Canada makes a mortgage payment, the equity in their property grows. The borrowed funds are then used to buy an investment that generates income, and because the interest on the loan is tax deductible, this lowers the effective interest rate on the loan.
  • The homeowner is instructed to borrow back the principal part of each mortgage payment and invest it in a portfolio that generates income.
  • Interest paid on money borrowed to generate revenue is tax deductible in Canada under the tax law.

The Financial Goal

First, a couple of basic definitions:

  • Your assets less any obligations represent your net worth. You must either grow your assets or lower your obligations, or both, to raise your net worth.
  • The amount of money that remains after all costs and debt repayments have been met is your free cash flow. You need to spend less, get a higher paying job, or pay less in taxes to enhance your cash flow.

Let’s look at a plan to help you create an investment portfolio, reduce your debt by paying off your mortgage more quickly, and boost your cash flow by paying less tax to help you raise your assets, reduce your debt, and increase your cash flow. In actuality, you would simultaneously increase your net worth and cash flow.

The Strategy

Every time you pay a mortgage, a part goes toward interest and the remaining amount goes toward principle. Your equity in the house will grow as a result of that principle payment, and you may borrow money against it often at a cheaper rate than for an unsecured loan.

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The effective interest rate on the loan is much greater if the borrowed funds are subsequently utilized to buy an investment that generates income since the interest on the loan is tax deductible.

The homeowner is instructed to borrow back the principal part of each mortgage payment and invest it in a portfolio that generates income. Interest paid on money borrowed to generate revenue is tax deductible in Canada under the tax law.

Since the principle payment is borrowed back each time a payment is made, your total debt does not change over time. But more of it turns into deductible debt for tax purposes. It is thus “good” debt. Less non-deductible debt, or “bad” debt, is also left.

Refer to the example below, where you can see that the $1,106 monthly mortgage payment is made up of $612 in principle and $494 in interest, to better understand this.

Image by Julie Bang © Investopedia 2019

You can see that every payment lowers the balance due on the loan by $612 The $612 is borrowed back and invested after each payment. This maintains the total debt at $100,000 while increasing the amount of the loan that is tax deductible with each payment. The accompanying chart shows that after one month of using this technique, $99,388 of the debt is still non-deductible but the interest on $612 is now.

This technique may be developed further: The part of the interest that is tax deductible results in an annual tax return that may be utilized to further reduce the mortgage. Due to the fact that it is an extra payment, this mortgage payment would be 100% principle and could be repaid in full by borrowing money and investing it in the same income-generating portfolio.

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The strategy’s phases are repeated on a monthly and annual basis until your mortgage is fully tax-deductible. As you can see from the preceding and next figures, the mortgage stays at $100,000, but the amount that is tax deductible rises each month. By the monthly payment as well as the income and capital gains that it generates, the investment portfolio is likewise expanding.

Image by Julie Bang © Investopedia 2019

As can be seen above, after the final amount of principle is borrowed back and invested, a totally tax-deductible mortgage would take place. The debt is still $100,000, but it is now entirely deductible from income. In order to accelerate the pace at which the investment portfolio expands, tax refunds might now also be invested.

The Benefits

The objectives of this approach are to increase assets and cash flow while lowering obligations. As a result, the person using the method has a larger net worth. Additionally, it tries to accelerate the process by which you pay off your mortgage and begin creating an investing portfolio.

Let’s look at these a bit closer:

  • Faster reach mortgage freedom When the value of your investment portfolio equals the amount of your outstanding loan, you are technically mortgage-free. Since your investment portfolio should be expanding as you make mortgage payments, this should happen quicker than it would with a conventional mortgage. The mortgage may be paid off even more quickly with mortgage payments combined with the money from tax deductions.
  • while paying down your mortgage, build an investing portfolio. A fantastic place to start saving is with this. Additionally, it helps free up money that you would not have been able to invest prior to finishing your mortgage.

A Case Study

Here is a comparison of the financial effects on two Canadian couples who paid off their mortgages in two different ways: traditionally and tax-deductible.

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Couple A paid $1,106 per month for a $100,000 mortgage with a ten-year amortization period at 6% on a $200,000 house. They invest the $1,106 they were paying each month for the next five years, earning 8% a year, after the mortgage is paid off. They have a portfolio of $81,156 and have owned their house for 15 years.

Couple B purchased a property at the same price with the same financing conditions. They invest the sum they have borrowed back each month. Additionally, they pay down the mortgage principle with the yearly tax refund they get from the tax-deductible component of their interest. The principle is then refinanced, and the funds are invested. Assuming a marginal tax rate (MTR) of 39%, the mortgage will be 100% good debt after 9.42 years and will begin to provide an annual tax refund of $2,340. They have owned their house for 15 years, and their portfolio is now worth $138,941. That is an increase of 71%.

A Word of Caution

This tactic is not suitable for everyone. It might be emotionally challenging to borrow money against your house. Even worse, if the investments don’t provide the projected profits, this method can backfire.

Re-borrowing against the equity in your house eliminates your safety net in the event that the housing or stock markets, or both, experience a downturn.

You can also incur extra tax penalties if you build an income-generating portfolio in an unregistered account.

To find out whether this plan is right for you, speak with a seasoned financial counselor. If so, ask the expert to assist you customize it to your unique financial status and the condition of your family.

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