Proper financial planning advice involves managing debt, as well as investments. For this column we’re addressing two common types of debt – mortgages and line of credits – and illustrating three common 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.
■ 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 5 per cent that is coming up for renewal. In the past, Mr. Wood has been making 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 pieces. He could name the piece he lives in as “Upper Level” and the other rental piece as “Lower Level”. By separating these two pieces 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, where as 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 Mr. Wood should apply to the Upper Level mortgage only. If Mr. Wood does not separate these two pieces then principal repayments would be applied equally to both, reducing current and future interest expense deductions.
■ 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 has been 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 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 then 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 is ineligible and not tax deductible. Dr. Wilson should do 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 and ineligible portions. It would also be a continuous accounting headache that he would likely have been charged extra to sort out each year.
■ 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 4 per cent. The problem we saw with this situation is that he had no interest deductions on Schedule Four 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. Mr. Muller had a fee-based account so no trading commissions would apply. We estimated the net capital loss after all investments were sold was $25,000 that he should carry-back to recover taxes paid two years ago.
The second step was to transfer the $150,000 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 (approximately 5 months addition to his existing term).
The third step involved the bank transferring the funds into Mr. Muller’s non-registered investment account for the purpose of investing. Extra care must be taken at this stage to ensure that the same investments sold at a loss in step 1 are not purchased within 30 days, or the loss would be considered “superficial” and not available immediately to him. We diarized the 30-day period to ensure the investments sold at a loss were not reacquired. Mr. Muller could repurchase the stocks that were sold for a gain with no tax problem.
Our recommendations focused on dividend paying common shares that he did not previously own. The above exercise will allow Mr. Muller to deduct the annual interest cost on the $150,000 debt linked to the investments. Mr. Muller should now focus on paying off the non-deductible portion of the debt, currently at $130,000.
Prior to acting on any recommendations within our columns, you should speak with your financial advisor and accountant to review your specific situation.