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How to deduct full mortgage interest when turning your home into a rental property

Saving money is difficult here in Canada, especially in Ontario.

When the government is charging over 50% personal income tax rate, for every dollar you make above the top bracket, you are only left with less than 50 cents to spend.

My parenting philosophy is to demonstrate by example. My daughter Robin is at the age when she learns everything by watching us. If we are on our phone all the time, all she wants is a piece of the phone so she can be on the phone all the time too.

Talking about demonstrating by example – the Ontario government will likely balance their budget in the future but it also plans to add another $30 billion in debt over the next few years, estimated to reach $326 billion in 2019.

If that’s how our government is showing us, the hardworking Ontarians, how to spend our money, no wonder it is difficult for us to save anything.

Just as we get excited about having free post secondary education for our kids, keep in mind 9% of our tax dollar paid is used to pay off interest now. Not debt yet!

If our debt is going up by about 10% over the next year, who knows how much our tax dollar will go into paying interest by 2019? And how much of it will be when our kids finally get to enjoy their so called “free” education?

There’s really no free lunch.

Now onto this week’s topic.


[private levels=”myrealestatetaxtips”]Over the weekend, we visited an old friend who lives in Unionville, Markham.

Unionville is a nice area, with many little boutique shops.

It is also the area where one of the best high schools in Ontario is located.

As most real estate investors know, great schools always increase the housing price nearby.

Our friends mentioned that they would like to trade their twenty year old home for a brand new modern looking home in Aurora eventually.

What if they don’t trade homes? What if they simply refinance their current home, pull out the equity, purchase their new home with this equity and turn this one into a rental?

Of course, we learned from my previous blog post that the interest incurred on money borrowed to earn investment is deductible and interest incurred on money borrowed to finance your own home is not deductible.

Savvy real estate investors like you and I may ask – is there a way to make the interest deductible?

I actually stumbled across this strategy last week.

The individuals would first sell their home to a corporation.

The corporation then issues a promissory note to the individuals.

Then the corporation would apply for a regular mortgage to finance this house. And use the proceeds to repay the individuals.

Therefore the entire mortgage interest on the presumably 80% loan to value of this house is deductible. Smart, eh?

The individuals can then use the money to purchase their new dream home.

One of the biggest disadvantages is that the couple would have to pay the land transfer tax.

When the individuals sell their home to the corporation, land transfer tax is triggered, calculated based on the fair market value of the house at the time the transaction occurred.

For our friends, their house is currently worth $1.4million. Land transfer tax will cost roughly $24,475.

That’s a lot of $$$ to begin with.

Of course, for taxpayers who live in Toronto, the land transfer tax can be doubled.

Definitely you need to look at whether the tax deduction on the interest is worthwhile making you pay the land transfer tax.

This couple paid $800,000 for the house a few years back. If their current mortgage balance is $500,000.

By refinancing the house to 80% loan to value, the couple can take out $620,000 to purchase their next home. Wow!

Let’s work out the numbers.

If they can borrow up to 80% loan to value ($1,120,000) in their old residence, the interest cost (with 2.5% interest rate) for the first five years is $131,268. Roughly $470K interest cost for the entire term.

We learn from the previous blog post that only the portion related to the rental would be deductible. In this case, only interest related to the $500,000 of $1,120,000 is deductible.

For the first five years, $58,602 is deductible and $72,666 is not deductible.

For the entire mortgage term (25 years), $210K is deductible and $260K is not deductible as a result.

Depending on how much money you make personally – if you are a high income earner, the tax cost is roughly 50% of the non-deductible portion.

If you don’t plan on selling the first home in five years, the tax cost for not deducting the interest is $31,333.   If you don’t plan on selling the first home forever, the tax cost is $130K.

Now compared to the land transfer tax you will have to pay to sell it to a corporation of $24K, it doesn’t sound too bad all of a sudden.

If you already have a corporation or small business to begin with, this strategy can be a better one. [/private]


Until next time, happy Canadian Real Estate Investing.

Cherry Chan, CPA, CA

Your Real Estate Accountant

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation.
5 replies
  1. Alex
    Alex says:

    Great article Cherry and Thank you for sharing this great piece of info.
    I am certain people will consider this strategy and use it to their benefit.

    Alex

    Reply
  2. John Nemeth
    John Nemeth says:

    Unless the corporation has been established for a long time and/or has lots of assets of it’s own, the bank might not issue a mortgage unless the primary shareholders guarantee it. If the individuals are guaranteeing a loan/mortgage for a corporation, they might not be eligible to get more credit.

    Also, rental income is passive income and thus isn’t eligible for the Small Business Deduction, so the corporation will have a high tax rate. Add in the cost and hassle of operating a corporation, and it sounds like this scheme is only suitable for very high income individuals.

    Reply
    • Cherry Chan, the Real Estate Accountant
      Cherry Chan, the Real Estate Accountant says:

      Hi John, great comment. I would say 99% of my clients are still using their own income or personal credit to qualify for mortgage. At the end of the day, unless you have a large portfolio (and sometimes even with a large portfolio), the bank will not approve your mortgage unless they have some security in your personal assets. Having said that, some banks do allow you to put the mortgages in the corporation’s name.

      Yes rental income is considered passive income. Keep in mind that the passive income is being taxed at 50% but 30% is refundable when the corporation declares a taxable dividend to the shareholders. With corporation, the advantage is flexibility of getting some of the tax dollars back. On the flip side, if you simply own the properties in your own name, it is less flexible.

      In my example, I did use a high marginal tax rate for the calculation. Tax planning strategies are not for everyone. They should always be consulted with your own professional accountants before implementing it weighing the pros and cons. (You can do the similar calculation with a lower marginal tax rate and see if it is worthwhile.)

      Cherry

      Reply
  3. Alex
    Alex says:

    Thank you.
    If this is the case how does the multi corporation structure works. There are people who advocate holding company, trading company etc. Does this structure has any merits in Canadian tax structure?

    Reply
  4. Darrin Roseborsky
    Darrin Roseborsky says:

    Really this is an insightful post with easy to understand examples which makes it a must read post for people who are looking to turn their home into rental property. With these smart tips followed properly many people can enjoy the great many benefits in Canada.

    Reply

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