Part 2: Why You May Want to Hold Off on Buying Your Home
How to Make Your Mortgage Tax-Deductible
For many Canadians, purchasing a home is regarded as an important step towards securing a stable financial future. Everyone has had a friend or relative say, “Why would you pay down someone else’s mortgage when you can pay your own?” That kind of advice may be commonplace, but is it true? Is buying a home actually a smart investment? In reality, while homeownership can certainly provide a sense of personal pride and stability, many people would be better off if they rented for longer – as much fun as it is to browse for properties online, holding off on buying your dream home may just be the best financial decision that you ever make.
In Part 1, we looked at why homeownership may cost more than you think. Now, we will discuss how to create a tax-deductible mortgage.
Creating a Tax-Deductible Mortgage
One of the biggest expenses of homeownership is mortgage interest – the cost that your financial institution charges for lending you money to purchase a home. In the United States, this expense can be deducted from your taxable income. In Canada, mortgage interest on a personal residence is, unfortunately, not tax-deductible. However, there is still a way for Canadians to create a tax-deductible mortgage and use it to their advantage.
If you borrow money to buy an investment that is intended to generate income – like dividend paying stocks or a rental property – the interest expense on that loan is tax-deductible. For example, if you buy a condominium and rent it out, the interest that you pay on that mortgage, among other business expenses, can be deducted from your taxable income. This tax rule exists to promote business activity and encourage investment, and it is also how Canadians can create a tax-deductible mortgage with a few carefully structured transactions:
Step 1: Purchase your home with as much equity as possible.
Step 2: Refinance the home to 80-95% of the property’s total value.
Step 3: Take this additional equity – the difference between your original investment and the refinanced amount – and purchase an investment that is intended to provide income.
There you have it, a series of transactions that now allows you to deduct mortgage interest from your taxable income. However, you may be wondering, “If I have the money to purchase a home outright, or with a significant down payment, why would I refinance my mortgage and take on additional debt?”
It is a good question, because we are often told that all debt is bad and should be paid off as soon as possible. In reality, there is “bad” debt and “good” debt. While consumer debt should be avoided, other debt can be used productively: to grow a business, pay for an education, or achieve investment returns above your borrowing costs. For example, by using the above strategy, you can use a tax-deductible mortgage to purchase the home you want while also funding a balanced and diversified investment portfolio.
To understand these different options, consider an example with an individual taxpayer earning $80,000 per year in Manitoba, Canada, who purchases a $400,000 home. Right now, mortgage rates are at historic lows, so we will use a conservative interest rate of 3% over a five-year fixed term.
|Scenario 1||Scenario 2||Scenario 3|
|Property purchased with a 20% down payment||Property purchased with a 50% down payment, remortgaged at 80% of the property value, and the funds invested in a dividend paying stock with a 5% yield||Property purchased outright, then mortgaged at 80% of the property value, and the funds invested in a dividend stock with a 5% yield|
|Mortgage Interest (Yr 1):||$9,422||Mortgage Interest (Yr 1):||$9,422||Mortgage Interest (Yr 1):||$9,422|
|Tax savings:||–||Tax savings:||$1,071||Tax savings:||$3,490|
|Dividend yield:||–||Dividend yield:||$6,000||Dividend yield:||$16,000|
|Total benefit:||$0||Total benefit:||$7,071||Total benefit:||$19,490|
The difference between these three scenarios is clear by looking at a one-year period alone – imagine the compound effect of these savings over time. Yes, in Scenario 1 we do not consider whether the individual has other investments. Nevertheless, because of how the mortgage is structured, they are not benefiting from the additional tax savings in the other two scenarios.
There are many variables involved in these types of transactions, and the effectiveness of this approach depends on your personal financial circumstances and, of course, comfort level with debt. However, if you have a small down payment (or even a substantial one), this tax strategy may be a good reason to wait even longer to purchase a home.
The Capital Gains Tax Exemption for Primary Residences
The capital gains tax exemption for primary residences is another important consideration for Canadian homeowners. If this exclusion applies to you, capital gains tax will not be owed upon the sale of your property for any increase in the value of your home above what you paid for it. While this exemption is commonly cited when providing the financial rationale for purchasing a home, transaction costs can quickly eat away at any value this provides, particularly if you make repeated housing purchases during your lifetime.
There is also no guarantee that housing prices will go up forever. Housing, like any other asset, is subject to price fluctuations. For example, when interest rates go up, the amount of money people can afford to borrow will decline, leading to lessened demand and reduced housing prices. While investing in real estate has been profitable for many Canadians, others have lost money – and even if housing prices go up, that equity is often entirely tied up in the family home. That is why, in Part 3, we will discuss the importance of asset diversification.
Of course, these considerations will not apply to everyone, and ultimately this decision will come down to your personal circumstances. The important takeaway is to consider all of the variables and consult with professionals who can help you avoid any problems. For example, interest is not tax-deductible on borrowed funds if it is invested in a registered account, like a TFSA or RRSP, and experts such as lawyers, accountants, and financial planners can help you navigate such issues in your transactions.
None of the foregoing is legal advice – it is always important to consult with a licensed professional when completing transactions or planning your financial future.