Should you make debt tax-deductible?

Yes, you probably should but not if you have lots of debt to begin with.  Let me explain as I carry forward this theme on debt from my earlier post this week – debt is a four-letter word for most of us.

Back to the question: should you make debt tax-deductible?

Maybe.  For well-to-do investors who have maxed out their TFSAs and RRSPs, those investors with a desire to invest more could decide to borrow money to buy stocks that generate income in taxable accounts. Generally speaking, you’re allowed to deduct interest on borrowed money used to earn income from a business, or property. Income from “property” includes interest income, dividends, rents and royalties. Be mindful, capital gains alone is not considered income.

Maybe.  Unlike our friends state-side, mortgage debt in Canada is not tax deductible unless you use the Smith Manoeuvre (SM).  This is a plan that takes years to execute so it’s not a jump-in then jump-out strategy. The premise is, this plan uses borrowed money from your home equity line of credit to invest in dividend paying stocks or income-producing Exchange Traded Funds (ETFs) in a taxable account (that means no RRSP or TFSA).

First, you need to obtain a re-advanceable mortgage.  This will ensure your Home Equity Line of Credit (HELOC) room will increase with every mortgage dollar paid.  Second, take money out of your HELOC to invest in aforementioned dividend paying stocks or ETFs that generate income in a taxable account.  On top of your regular mortgage payment, you can make additional mortgage payments from the dividends (or distributions) paid by your taxable holdings.  Three, when completing your tax return, deduct the annual interest paid amount from your HELOC account.  Four, apply the tax credit received from the HELOC to pay down your mortgage which will open up new HELOC money available.  Again, the more your mortgage goes down the higher your HELOC could be and the more you could invest in a taxable account to generate income.  Rinse and repeat until your mortgage is paid off.

Even though you are paying interest on your HELOC, the fact that you are going to get a tax deduction for the interest paid, plus the fact that your investments should (hopefully) provide you with a return that is higher than your loan interest rate, it should result in net gains for you.  In theory, like an older blogpost from Canadian Capitalist mentioned “equity returns will beat the tax deductible interest payments on the loan and over the long-term you’ll come out ahead with the SM than just paying down the mortgage.” That’s the theory of this leveraged investment strategy. This approach comes with a number of risks and you can read a few of those considerations here.

“You can’t fix what’s broken if you don’t know where the money is going.” – The Money Buff

Money and debt is an emotional subject because how and when you spend your money might equate to what’s important to you.  People have very different ideas about money and debt because of their personalities and what they experienced growing up.  I’ve been passionate about money management in recent years because I value our time more as the years tick on.  I/we live for today, we certainly spend our fair share of money but we also make conscious decisions about it too.

Reading about personal money management can be intimidating with all the graphs and charts and numbers that are found inside many books – that’s not for everyone – that’s not always good for learning either. To pique your interest consider some books that use stories like the recent Money Buff book I read (thanks for the copy) or reading classics like The Wealthy Barber.  You can also consider reading blogs, visiting forums or checking out the personal finance sections of major newspapers for money and debt tips. Consider subscribing to MoneySense or Canadian MoneySaver for a year or so as well.  These subscriptions might cost you $25 or so per year but the advice could save you thousands of dollars.  You can also read this post about Just Starting Out – I provide lots of great references.  Finally keep reading this blog and share it with others.  I tend to raffle books and post expert perspectives now and then.  On that note, stay tuned for another book giveaway soon!

Personal finance is personal and no two people see money and debt the same way.  That’s OK.  Debt can be a valuable tool when used responsibly but it can also smoother your financial dreams.  Only you can decide how much you dislike debt and whether debt is another four-letter word for you.

In debt?  Out of debt?  What does debt mean to you?

5 Responses to "Should you make debt tax-deductible?"

  1. Mark, this article resume pretty well the SM

    If we put aside our disdain for debt, SM is a great idea but NOT for everyone. You listed a lot of things to consider before doing it. To me, the checklist is the following: You must have no other debt than mortgage, your marginal tax rate should be 38% or more. If you have high MER mutual funds or your investments include bonds, get rid of it before thinking to leverage. If you cannot handle to be 100% stock or variable rate mortgage, you will not stomach leverage! Emergency fund should be at least 3-6 months (liquid, cash-alike). If your saving rate is 10% or less, your budgetis to tight to take chances with more debt. Keeping a proper track of all trades, interests, dividends and capital gain, for tax purpose can be a chore for some but others (like me) just enjoy doing it.

    For most, it’s still better to focus reducing taxes (RRSP) and save a lot (TFSA) with low fees ETFs. Reducing debt directly with lump sum is also a safe, good and simple idea!

    1. Thanks Le Barbu, I’m glad you enjoyed the article.

      The SM is not good for everyone, for sure.

      I have a bias to my path, not surprising, we all have biases, to max out our TFSAs and RRSPs first, then consider the SM once the debt is more manageable. We’ve got my wife’s RRSP to max out, otherwise, we’re doing OK. Once all TFSAs and RRSPs are maxed out by 2017(?), we think?, then if the mortgage is down to $50k or so we’ll consider it. For now, I will keep my disdain for debt 🙂

  2. I think you hit the nail on the head that if folks figured out that they could make (some) of their debt deductible, they might just “dig a bigger hole” for want of a better term. I know many friends in the states who put their car loan inside of their mortgage and made that debt “tax deductible”, but is that a good idea?

    1. I think making tax-deductible is a good idea as long as you’re not digging yourself a deeper grave. That’s just me but I’m largely anti-debt when it comes to personal finances since the more you pay other people money the less you keep for yourself. I’ll be very happy when I’m mortgage-free but I know other people don’t agree with that statement.

      You excluded I think!


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