The older a kid gets, the more able he is to take advantage of his younger siblings. It's a rite of passage, I guess. My oldest son has figured this out. This week, he took a handful of pennies - about $1.27 worth - and offered them to his younger brother in exchange for two of his brother's toonies. My little guy jumped at the offer to make the swap thinking that the handful of coins had to be better than having just two coins. Now, there's a swap that didn't make much sense.
Today, I want to talk about another type of swap. This one can save you tax dollars. I'm talking about a debt swap.
THE CONCEPT
Take a look at your balance sheet. Do you have any debt? If so, are you entitled to deduct the interest? Chances are, you've got some debt that is costing you interest that is simply not deductible for tax purposes.
You see, Canadian tax law allows a deduction for interest costs, but only where you've used the borrowed money to earn income from business or property - that is, to earn interest, dividends, rents, royalties or business income. The problem? This usually excludes your mortgage interest, or interest paid on other debt used for personal consumption or to purchase non-income-producing assets.
What if you could make the interest deductible on some of that "non-deductible" debt? This will reduce your cost of borrowing by providing some tax savings. If you're in the highest marginal tax bracket in Ontario, for example, you'll save just over 46 cents in taxes for every dollar of interest you deduct.
The good news? You may be able to swap your non-deductible debt for other debt, which can give rise to interest deductions.
THE STRATEGIES
The first strategy to consider is the traditional debt swap.
Picture this: You've got some investments that you own outside of your registered retirement savings plan or registered retirement income fund. You also have some non-deductible debt.
Consider liquidating some of your investments, and using the proceeds to pay down some of that non-deductible debt. Then, you have the option of reborrowing that same amount to replace the investments you just liquidated. If you do this, you'll be borrowing for investment purposes, which should now enable you to deduct your interest costs if you've invested properly, to earn income. Your total debt remains unchanged, but you're able to deduct interest.
A couple of things to note here.
First, be sure to count the tax cost of liquidating your investments. Now, this economic climate may be a very good time to consider the strategy because you'll likely realize some capital losses rather than capital gains if you carefully choose the securities that you sell. Just be sure to wait at least 30 days before reacquiring the identical securities if you hope to replace them again, otherwise the superficial-loss rules can deny your capital losses.
The second idea is much like the first, but works well if you don't have investments currently available to sell off and pay down your non-deductible debt. This strategy is sometimes referred to as the "Smith manoeuvre" (since it has been broadly marketed by Fraser Smith, who may lay claim to "inventing" the strategy; in fact, the strategy has been around for many years and has gone by different names).
Here's how it works: As you make your mortgage payment each month, a portion of that payment is interest, but the rest is applied against the principal amount owing. As the amount you owe on your mortgage declines each month, you will borrow that amount and invest it in a diversified portfolio of investments.
You'll then be entitled to deduct the interest on that newly borrowed money if you're investing to earn income. That interest deduction will result in some tax savings. You will then take those tax savings, along with the income earned on the portfolio, and you'll pay down your mortgage further. The idea is to repeat this process until your mortgage is completely paid off. At that point, you'll be left with a portfolio of investments and an investment loan on which you can deduct the interest.
As a practical matter, you'll want to set up a readvanceable mortgage that has two components: A regular mortgage and a home equity line of credit. As the mortgage balance declines, the amount available on the line of credit automatically increases, allowing you to borrow on that line of credit to invest. Many financial institutions offer this type of facility.
Next week: A primer on borrowing to invest.