One day, years ago, I was minding my own business when the PMO called. “The prime minister wishes to see you this afternoon,” a voice said. Four hours later I was sitting on a floral couch looking down on the Ottawa River gorge drinking tea from bone china served by a dude in gloves.
So the next day I trotted off to Rideau Hall and was sworn in as Minister of National Revenue, which I thought was cool because I got a car and driver. My euphoria ended when I met the deputy minister, a career civil servant who apparently hated taxpayers. Revenue Canada, the thing I was now running with 18,000 employees, seemed to delight in hounding and harassing people, neither of which were producing more revenue.
So I decided to do two things. First, read the Income Tax Act. That way no civil servant would bamboozle me with a, “yes, minister..” routine. But the damn thing was half a foot thick. Second, I’d declare a tax amnesty, so anybody who actually owed money could come forward, pay up, be thanked, and not slapped around with fees and penalties.
See why I made such a lousy politician?
The point of this pointless story is to admit I actually got a little off on the tax code. And to this day I still spend enjoyable hours reading CRA Interpretation Bulletins. In fact, understanding how you’re taxed – and how to avoid it – is probably more important that learning how to invest. I know medical professionals, for example, who earn $400,000 a year and will never pay a cent in income tax. They game the system.
But what does this have to do with the poor schmuck who owns a house and lives a normal life? Plenty. Here’s a question from Phil:
Garth, first thank you for all the advice. Your ‘non-cowboy’ post a week or so ago was particularly valuable.
Over the last few years I built my own home in downtown Ottawa. I think its value is peaking, but I’m going to stick with it since it’s home and tailor made. However, I have a rental property I think I will dump…Anyway, the question:
How can you deduct mortgage interest from your taxes? I’ve noticed you hint that it’s possible, but you’ve never explained. There are two scenarios in my case: first is my primary residence and the second is an income property.
Let’s deal with the rental property first. Any time you own real estate which is 100% income-producing, all of the interest is deductible from that income. Of course, this also means you have to pay capital gains tax on any money made when the place is sold. But it’s still a good deal. Rental income is considered the same as earned income, which means it’s taxed to the max – added on to your personal income, often kicking you into a higher tax bracket.
So being able to deduct interest is a significant benefit. This is also a reason you never want to accelerate mortgage payments on a rental property. As for the capital gain, it’s far less than most people think – the tax is only on 50% of the windfall, calculated at your marginal rate. So, for example, if you sell a place and make $50,000 in profit, and you earn $70,000 then the capital gains tax is 33% of twenty-five grand, or just $8,250. You keep the other $41,750.
So how about a tax-deductible mortgage on the house?
There are a few ways I know. Probably the simplest is for people who have both a mortgage and a portfolio of liquid investments. First, liquidate your investment assets. Then use the cash to pay off your home loan. Now negotiate a new mortgage for the same amount, but this time I’d take out a long-term fixed-rate home loan with a higher rate. Two reasons for this – rates have only one direction in which to travel, plus you get to deduct more interest from your taxable income.
Use the proceeds of your new mortgage to repurchase the same assets you owned before in your investment portfolio. And, voilà, now you have a totally tax-deductible mortgage. You also have maintained your investment account, which means you’ve diversified your net worth, instead of concentrating it in one thing. Risk off.
If your new mortgage is 4% on a $300,000 borrowing you’ll be able to deduct $55,838 over the next five years from your taxable income. This amounts to more than half of all the mortgage payments combined. Meanwhile your investment portfolio can continue to grow, and at a 7% annual rate it will have increased about 50% within those same five years.
Will this strategy make ya rich? Of course not. But it sure beats paying your mortgage out of after-tax dollars, or dumping all your wealth into your house and rolling the dice on the real estate market. What danger there is lies in not having a balanced, non-cowboy investment portfolio.
Oh yeah, or getting elected.