The tax-trashed mortgage

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  By Guest Blogger Sinan Terzioglu

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When I lived in the US and considered purchasing a home I learned mortgage interest for a personal residence is tax-deductible if you meet certain qualifications. This certainly provided a good incentive to seriously consider buying.  After returning to Canada I heard about a strategy of converting a non-deductible mortgage into a tax-deductible investment loan so I was curious to know if it made sense for me.

This is a legal tax strategy which involves homeowners making principal payments against their mortgage, then borrowing the same amount from a home equity line of credit and using the funds to purchase income generating investments.  The interest on the loan is tax-deductible so the strategy essentially converts a non-tax deductible mortgage to a tax-deductible investment loan.  The overall debt does not increase but the risk does as you would be leveraging your equity and taking on investment risk.

To execute, you need to obtain a re-advanceable mortgage which is a type of mortgage that includes a home equity line of credit (HELOC).  Funds drawn from the HELOC would then be used to purchase investments with a reasonable expectation of generating income such as dividends from equities, interest from fixed income securities and/or rental income from an investment property.  The interest payments on the HELOC are tax deductible which results in a tax refund that would then be used to make prepayments on your mortgage with the goal of paying down the balance owing more quickly.

For example, suppose you purchase a home for $1,000,000 and obtain a re-advanceable mortgage of $500,000. The re-advanceable mortgage gives you access to an initial HELOC limit of $300,000 which is calculated as the maximum of 80% of the value of the home minus the mortgage balance.  As you make monthly mortgage payments the principal portion paid down enables borrowing additional funds from the HELOC equal to the principal just paid and letting you invest in additional funds. Over time the net debt stays the same but the result is a growing leveraged investment portfolio until the mortgage is completely paid off.

Let’s assume your HEKOC rate is 4.50% and you use $300,000 available to invest in year one.  The annual interest charge would be $13,500 so with a marginal tax rate is 40% you could expect a tax refund of $5,400. Use that plus the income generated from the investments to pay down the mortgage.  The process is repeated until your mortgage is paid off.

From a purely financial perspective the strategy makes a lot of sense if the investments provide a return higher than the loan interest rate.  For those who have implemented the strategy over the long term and invested in high quality productive assets they have been able to pay down their mortgages sooner and increase their net worth more quickly and in some instances fairly significantly.  All that said, after careful consideration of all the benefits of this plan and having the confidence in my long term income generating investment strategy, I decided it was not for me and I do not recommend it for most Canadian homeowners.

The financial crisis of 2008-2009 and the recent COVID-19 crisis have once again highlighted how important it is to have a stable foundation to be able to withstand economic turmoil.  In my opinion, nothing is more important than the capacity to survive the most difficult times. While the probability of markets rising over the long term is high there are many other risks that can have a significant impact on this strategy in the near to medium term such as:

• Interest rate risk. Higher rates will lead to higher borrowing costs on the HELOC but also potentially pressure investments and the value of your home.
• Investment risk. Poor investment choices could easily lead to the permanent loss of capital. Some novice investors have reached for yield in individual securities and as a result have lost significant amounts of capital because they perceived certain securities to have safe dividends only to see them reduced and sometimes eliminated which has led to significant declines in shares prices.  There is no shortage of examples across several sectors in Canada such as the energy sector.
• Behavioural biases. It is extremely important to know your risk tolerance.  Equity markets will continue to be volatile and there will be years when markets drop 20%+ in short periods of time and possibly more.  How you behave in these times could have very big implications on your long-term wealth.
• Leverage risk. Borrowing to invest amplifies your results in both good times and bad but I think Warren Buffett’s quote about leveraged investing says it all:

“It’s insane to risk what you have and need for something you don’t really need.”

Adopting a survival mindset is essential when developing and sticking to a long-term financial plan.  To do well you simply have to live within your means, invest and earn a reasonable long-term rate of return.  By following Garth’s Rule of 90 you shouldn’t need to utilize leverage to reach your financial goals.  The key to achieving longevity in your long-term financial plan is to increase your probability of success and the most optimal approach is to have balance not just in your investment portfolio but across all of your assets.

If you are considering this strategy for yourself, only do so if your time horizon is at least 10+ years so you increase the chances of the strategy working out.  Also, ensure you keep very close track of all the interest paid and income received from your investments because if the CRA ever audits your tax return you’ll have to clearly explain yourself.  The HELOC funds must be invested in a non-registered account only and cannot be used for contributions to your TFSA or RRSP otherwise the interest would not be tax-deductible.  Most importantly, the funds should only be invested in very high-quality securities and/or diversified ETFs.

Sinan Terzioglu, CFA, CIM, is a financial advisor with Turner Investments, Private Client Group, Raymond James Ltd.  He served as vice-president of RBC Capital markets in New York City and VP with Credit Suisse in Toronto.

About the picture: “Like most, she was Born to Serve. Always wanting to work.  Obsessed about chasing and returning things (mostly balls, the occasional sock and loved stuffed animals!),” writes Chris. “Kaia’s raison d’être was to bring a smile to a face, and make people feel happy.  It was a mission. On our walks she would ignore other dogs but stare at their owner.  Often she would sit patiently and wait carefully observing an individual.  It would bring me so much happiness to see how she would watch other people patiently waiting just to be noticed.  Then once eye contact was made there was no hope for any poor soul.  She would draw them in.  They couldn’t resist; no matter how bad their day was.  She would paste herself to their leg and let out a whimper as they touched her soft coat. She would make the grumpiest curmudgeon smile, appreciative for any love or kindness they showed. Once the smile broke out she knew her work was done. Thank you for sharing my memories of her. Here for a good time.  Not a long time.  Many good memories to share.  A more peaceful world.”