Find Great Tips &
Strategies Here that the
Banks Won’t Tell You
Get All The Tax Breaks You Can
Turn bad debt into good debt. Organize your debt to avoid having to pay tax on the interest.
One of the oldest proven methods, used by wealthy Canadians, is to arrange debt to avoid having to pay tax on the interest.
Using the same strategy over time can result in sizeable tax returns.
When it comes to the tax angle, there are two kinds of debt: good debt and bad debt.
- With bad debt, i.e. credit cards and car loans, you have to pay interest with after-tax dollars.
- Good debt consists of any debt incurred from business expenses, business investment, stocks or equity mutual funds. Interest on all these is tax-deductible.
The strategies we're going to show you involve swapping bad debt for good. However, there are two things you should keep in mind:
- Make sure your credit rating is in order, and you have proven to yourself that you can handle debt.
- If you’re thinking about implementing these strategies, it is important to work with an accountant or a certified financial advisor.
If you already own stocks or equity mutual funds outside of an RRSP portfolio and also have equity in your home, you can effectively convert your bad mortgage debt to good debt through an asset swap.
In simple terms, this is a financial deal where you exchange the cash flows from different assets you own. An asset swap allows you to change the source of income from your assets to better match your needs.
Here's a simple scenario
Let's say you owe $60,000 on your mortgage (bad debt) and you also happen to own $60,000 worth of shares in a Canadian corporation. To execute the asset swap, take the following steps:
- Sell the shares.
- Use the proceeds to pay off your mortgage.
- Borrow $60,000 based on the equity in your home.
- Re-deploy the $60,000 in an eligible investment (i.e. stocks or equity mutual funds). If the shares you sold look good, you can make a similar investment.
Your debt situation hasn't changed, but your loan is now for the stock, not for your home, and your interest payments, are therefore tax deductible. This is effectively the same as having a tax-free mortgage.
Of course, in real life, the numbers won't work out this perfectly. You might owe $80,000 on your mortgage and own a $25,000 matching asset. In this case, you can use this method to convert $25,000 of your "bad" mortgage debt to "good" tax-free debt. The interest on the remaining $55,000 would still be taxable.
If you don't have a matching asset to sell and re-buy, you can gradually convert your bad mortgage debt to good tax-free debt through a systematic process.
While financial advisors sometimes package this process as a tax-free mortgage, there are limits to how much tax sheltering you can achieve.
The mechanics are that you reborrow a portion of each mortgage payment and invest the money in stocks or equity mutual funds.
The money you reborrowed is now good debt, i.e. interest payments are tax deductible. As you start to pay interest on the loan, you will generate tax returns, which can be used to pay off the mortgage more quickly.
The added equity in your home allows you to borrow more and grow your investment portfolio faster. The process creates an accelerating snowball effect.
The result can be years taken off your mortgage with no increase in payments.
It's important to note here that you are incurring debt for the equities at the same rate as you are retiring debt for your home, so your debt level remains constant.
Once your mortgage is paid off, you are still in debt, but the investment portfolio you've acquired should balance your liabilities.
It is essential that you consult an accountant or certified financial advisor if you want to follow this strategy.
If you own an unincorporated business, the Canada Revenue Agency (CRA), treats you and the business as the same entity.
However, if you are an incorporated business, business expenses become tax-deductible and you can use them to incur business debt and free up your cash flow to pay off your mortgage, your car loan, or any other debt, more quickly.
The advantage is that interest payments on business loans are tax deductible*. (Note: Paying yourself out of the business does not denote a business expense. This has to be money that you pay to others.)
The same method can be used if you own rental property or rent out a space in your home. You can borrow to pay any related expenses you have related to your rental property. The interest you have will be tax deductible if specified for rental property use and the extra cash can go directly into your mortgage.
*Some restrictions apply. Consult your accountant or certified financial advisor.
The program allows you to invest before-tax dollars, as opposed to after-tax dollars, into your personal retirement fund.
This creates a deduction and the Canada Revenue Agency (CRA) will reduce your payable taxes by a marginal tax rate reflective of your contribution and tax bracket.
Other methods of tax savings should always be weighed against what you could save by contributing to your RRSP. This is especially true if building up that fund is a priority.
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