Entries from October 2012 ↓

Tax avoidance

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.

Street value

Some months ago I told you about a hotshot young lawyer who bought a hotshot house in swishy North Toronto for $1.25 million. He put 5% down, tacked on a few closing costs and mortgaged it for $1.2 million. Now he had a driveway for his leased BMW. Because he made $300,000, but had no actual money, the bank gave him the down payment in the form of a cash-back loan, and Ottawa guaranteed his borrowing.

Oh my, how things have changed.

Today the same house no longer qualifies for CMHC insurance, since the feds cut off $1 million-plus properties. That means a 20% down payment. Plus, quietly, bankers have bowed to pressure from the regulator and adopted new loan-to-value limits. In Toronto, that’s 80% to a million, and 50% of the rest. On a $1.25 million house, the max is $925,000 in financing. And there are no more cash-backs. It all means, with closing costs, the buyer now needs $375,000 in cash.

This is probably why there are no more multiple offers in the hood. Seven months ago the house would have fetched 15% above list. Not it’s likely to get 10% less. That’s a decline in street value of $312,500, or 25%.

This is why projections from Bay Street economists that real estate will have a ‘soft landing’ of 5-7% are so yesterday. Just 100 days after F tanked amortizations, with CMHC and the bank cop ushering in new regs, real values are in retreat. High-income buyers – even lawyers making three times the average family wage – are now booted out of the market because of a credit restriction.

Meanwhile, as I described yesterday, the bottom end – condos, mainly – is being severely thumped by the death of 30-year amortizations, the end of cash-backs and higher standards for virgin borrowers. Buyers without savings who last year could buy a condo more easily than a Kia and now forced to retreat to mom’s basement. Oh, the infamy.

Conditions are changing quickly, if you haven’t noticed. The Bank of Canada’s ‘slow-growth’ rhetoric yesterday is something you’re going to hear a lot more about. The world is tilting more towards deflation than inflation, and in Canada real estate will be the fall guy. This is one reason why, at the Ol’ Time Revival Meeting last night in Toronto, I let people know a 20% price reduction across the GTA is now a distinct possibility. Some hoods will be more impacted than others, but the downward momentum is now obvious.

But, Angelo asks, what if you know a price dump is coming, and you can’t sell, for wife reasons?

“My situation is the wife refuses to sell as she likes the “security” of owning our home (condo actually) and the low monthly carrying cost “if anything were to happen”. We’ve been mortgage free for about 2 years; purchased the 1400sqft. condo in 2006. We have many “discussions” about why we should sell now, but she gets very emotional at the thought of moving or selling. At least she agreed to come to your talk last night.

So… if the issue of selling will cause more marital strife than it’s worth, should I instead be looking at leveraging RE to take advantage of the low rates, tax deductible interest, and try to mitigate my RE asset deflation with a balanced/dividend yielding portfolio? (Another relevant financial metric is that we have almost $400k saved and invested between my wife and I in RSPs, TFSAs, and other unsheltered accounts including the Orange Guy’s Shorts.)”

Well, Angelo, sounds like you already got the memo about diversification and liquidity. Having $400,000 in financial assets is good, but not in the OGS. There’s no longer any such thing as a ‘high-interest savings account,” since every one is paying less than inflation and yielding fully-taxable interest. Why would you not have that money in bank preferred shares, or quality real estate investment trusts, or even a low-cost dividend or monthly-income fund?

As for the equity in your paid-for condo, a fifth or a quarter of it could melt away over the next year or two, and never return. If the place is worth $500,000, that’s a loss of at least $100,000 in capital gains tax-free wealth. Is that what your wife means by “if anything were to happen”? How would she feel about holding financial assets and losing a quarter of them? Would she ever forgive you?

At least you could counter the decline and loss in equity by removing some of the money and getting it growing. A home-equity line of credit would let you access funds and get tax-deductible interest at the same time. Hopefully your bank could give a secured line at prime (3%), so after taxes it might only amount to 1.8%. If you can invest in stable bank preferreds (just an example) giving 5.2%, payable in lowly-taxed dividends, then the net spread should be about 2.5% in your favour. A diversified portfolio with a 40/60 fixed/growth split would likely do much better, but with more volatility.

Should you do it? Ask her. There’s no rate of return which can compensate for a busted marriage.

But I’m sure after last night, hallelujah!, she is saved.