Tuesday, September 18, 2018

Interest Tax Deduction when Borrowing to Invest

Last week’s article on Smith Manoeuvre risk sparked reader RS to ask the following thoughtful (lightly-edited) question:

Have a mortgage and have non-registered investments (mostly in XIC) that can cover a significant portion of my outstanding mortgage. Wondering if it will make sense to pay off the mortgage using non-registered investments and take a HELOC and buy the same (or similar to avoid attribution) assets. I will be in the same position as I am now, but now I will be able to write off interest (which will be about 25% more in HELOC). My marginal rate is 50%, so I guess it might be advantageous. I will also need to factor in any capital gains taxes (25% of gains) that I will incur now against the savings. But this thinking sounds too simplistic. Not sure if I am missing something here.

I don’t think you’re missing much. Given that you have had a mortgage at the same time as building non-registered investments, it would have been better to have set things up to make your interest tax-deductible from the beginning. But that’s water under the bridge now.

If we take it as given that you will maintain your leverage, then whether to proceed with the change depends on the numbers. You can project a likely outcome over whatever period of time you plan to maintain your leverage, calculate your costs and savings in each scenario, and choose a winner. I’m guessing the numbers will favour making the change to make your interest tax-deductible, but I’d have to see all the numbers to be sure.

Keep in mind that CRA has a number of requirements you have to meet before they will allow you to deduct interest costs. Be sure you understand them before you proceed.

The purpose of my original article was to make people think about whether they want to leverage their stock investments at all. So, in addition to possibly making the change you’re contemplating, you should consider whether to just pay off your mortgage to reduce risk and not get a HELOC.

Whether this lower-risk scenario makes sense can’t be determined by running numbers on most likely scenarios. You choose to de-risk based on the possibility of a very bad scenario. Would a crash in stock prices, house prices, and widespread layoffs leave you devastated, or would you be okay? This is the right way to think about the level of risk you take on.

My personal choice years ago was to pay off my mortgage before I started building non-registered investments. Only you can decide how much risk you want to take on.


  1. Good write up and question. I did something similar a while back. Agree that it will come down to the numbers. For what it's worth, some things you will need/want to think about in the numbers are:

    - You have to avoid superficial loss (CRA rule Michael mentions) so make sure you're aware of that
    - You will have to factor in Cap Gains as you stated. Given that we're near the end of 2018, it may be possible to do this in a couple tranches to mitigate, if that makes sense (if you are in a 50% bracket, probably won't help much)
    - Any early / pre-payment fees on your mortgage? Depending on size & term left, they could be significant. Make sure you understand them
    - Do you have a HELOC set up already (to re-borrow against?) If not, there will likely be a fee associated with setting this up. Some banks will eat the fees if you move a big enough balance
    - Though nothing is guaranteed, a couple future BOC rate hikes (maybe 0.5% total) are expected. If your mortgage is fixed, this would serve to disadvantage the business case. If your mortgage is variable now anyway, then it's a wash.

    I'm sure there's others, these are just a few of the things I had to consider.

    1. @Anonymous: Some excellent points. It's important not to assume that prepayment penalties on a mortgage will be modest. Some banks play games with their rules to boost these prepayment penalties to impressive levels.

    2. @Anonymous: Thank you. I need to enquire about HELOC fees. Aside, I am on variable rate. What got me thinking was primarily the future rate increases. As it increases, the ratio of HELOC rates to variable rate will continue to diminish making writeoff even more attractive. About 2 years back HELOC was 35% more than my variable. Now it is only 25%.

  2. Indeed, the questioner is giving up free money in the form of the interest deduction, assuming they are comfortable with the leverage and (as you say) with their level of risk more broadly.

    What's more, it's not necessary that they switch to a HELOC. It is quite fine (from a tax point of view) to borrow to invest using a regular mortgage, benefiting from a lower interest rate, of course in return for less repayment freedom.

    That being said, given interest rates are (still) very low, it is unlikely to make sense to crystallize a whack of taxable capital gains, and especially pay any penalties to pay off the mortgage prior to reborrowing.

    We happily took out a mortgage to invest when I got married and we combined living arrangements. We were collapsing our portfolio(s) anyway, to purchase a home outright, and so it felt natural to avoid having all of our savings "locked up" in real estate. But it would probably not have made sense if we didn't have an "event" anyway.

    1. @Martin: Quite right about the HELOC. There needs to be a straight line from the borrowed funds to the investments, so the current mortgage has to be paid off. But, the new loan can be a standard mortgage.

      I agree that whether making the change makes sense depends largely on the capital gain and mortgage prepayment penalty. If selling the investments would result primarily in return of capital and no mortgage prepayment penalty would apply, then the change probably makes sense. It's all in the numbers.

  3. Thank you Mike for your response and the comments in the section. I need to run the numbers. I like starting with a clean slate and may have to sell some in my and my spouse's TFSA to completely close the mortgage off. I will to have to fill the TFSA back up again through non-HELOC funds.