Making Your Mortgage Interest Tax Deductible

The following only applies to Canada. US resident can already deduct their mortgage interest off their income tax. This is something Canada doesn’t allow. However, there are few moves Canadians can do to close this interest deductibility gap with our US neighbors. Please see a qualified financial planner before trying any of the following.

Have a Business at Home

If you run a business from home, you can deduct the mortgage interest on the portion the home business takes up. Say you use 20% of your house for your home business. That mean 20% of the mortgage interest can be deducted from your business expense. The disadvantage of this setup is the business portion of the house could be subject to capital gains when you sell it. Noticed I said could be. It’s not a hard and fast rule – it depends on how long and how much of the house is used for your business. If you keep it short and small, then you don’t have to worry too much about possible capital gain tax. However, if you’ve been running the business out of your house since you brought it and you’re using more than 50% of the house for business, you can be sure the CRA will want a cut when it comes time to sell.

Rent Out Part of The House

Many home owners rent out un-used parts of their house to help pay their mortgage. In this case, the house is still their principal resident but it also produces income. If you were to live upstairs and rent downstairs, you can deduct the interest on the downstairs’ portion of the house. However, most people in this kind of situation don’t do this for a few reasons. The first is, if they deduct the interest, they have to report the income made from rent and that normally results in them owing more than they get back. Of course not reporting the rental income is illegal and I am in no way advising people to do this. I am just stating the reality of many rental situations. Also, if the property is rented for a long time, the CRA can rule the portion rented be subjected to capital gain tax when you sell.

The Flintstone Flip

This method goes by many names but I like calling it the Flintstone Flip. The Flip allows you to make 100% of your mortgage interest tax deduction while preserving the tax free capital gain status of your principal residence. The Flip requires you to hold an amount of asset that is equal to the mortgage value of your home. Say you have a $500,000 mortgage that is coming up for renewal, and you also have $500,000 of investments. What you do is sell the investments and use the proceeds to completely pay off the mortgage. Now you have a free and clear house and no investments. Go back to the bank, put a new $500,000 mortgage (or home equity line of credit) on the house and use the money to buy back the investments. Now you are back where you started – a $500,000 mortgage and $500,000 of investments. Only now the mortgage interest is tax deductible!

Interest on money borrowed to buy your home is not tax deductible, but interest on money borrowed to buy investments is. In the above example, the $500,000 wasn’t used to buy a house but to buy investments instead. There are rules to doing this so make sure you have the advice of your financial planner or accountant before you proceed. Also, I said you use the money to buy back your investments. In a real life you will buy different investments instead. Buying back investments you sold can be viewed by the CRA as you trying to avoid taxes. The CRA is well aware of this financial move but haven’t done anything to stop it other than creating CNIL (that’s for a future blog post). The reasons it hasn’t done anything to prevent Fred from doing the Flintstone Flip is because very few Canadians have enough assets outside of their house to pull this move off. And those that do have the means to pull off such a maneuver pulls the government’s purse strings, if you know what I mean.

The Smith Manoeuvre

The Smith Manoeuvre is a twist on the Flintstone Flip. Basically you would turn your non deductible mortgage into a deductible one over time. As you pay down your mortgage each month, an amount equal to what you pay down is re-borrowed to buy investments. The interest charged on the investment part becomes tax deductible. The deductible interest will trigger a tax refund which can be use to help pay down the mortgage faster, allowing you to borrow more for investments. Over the life of the mortgage, you will be shifting it from non deductible to fully deductible.

The manoeuvre is attractive to people who don’t have enough outside assets to do a Flintstone Flip. It allows for the normal pay down of a long term mortgage with tax deductibility of a leveraged investment. Like the Flintstone, the Smith is subject to CNIL. Again, talk to your financial planner before trying any of these strategies.