Five strategies for borrowing money the right way
Tim Cestnick is president and CEO of WaterStreet Family Wealth Counsel and author of 101 Tax Secrets for Canadians.
If you borrow money - do it right. First, don't borrow in Spain. Debt collectors in Spain are permitted to humiliate those who fail to repay their loans. According to The Wall Street Journal, one debt collector uses bagpipe players to announce the debt to the entire neighbourhood. Another sent a bill to each person on a guest list for their "share" of the debt owed from a wedding. Second, pay off your debts even if you don't borrow in Spain. Finally, take advantage of interest deductions on your borrowed money.
Last week I provided a primer on deducting interest. Today, I want to share some specific strategies that could give rise to interest deductions and tax savings.
Use "cash damming" to deduct interest.
This is the idea of segregating (usually in separate accounts) the cash received from borrowing money and funds you might have received from other sources. Last week I talked about the importance of being able to trace your borrowed money to specific uses that will give rise to an interest deduction. Although it's not mandatory, cash damming will allow you to trace the use of the borrowed money more readily.
Undertake a "debt-swap" to create deductions.
You may be able to restructure your borrowings to create an interest deduction. If you have liquid investments today, and you also have debt that does not give rise to an interest deduction, consider a debt-swap: Consider selling your investments (count the tax cost first) to fully or partially pay down the non-deductible debt. Then reborrow to replace those investments. Your total debt won't change, but the new debt will generally give rise to an interest deduction since the newly borrowed funds can be traced to an income-producing purpose.
Complete a corporate debt-swap.
The debt-swap above works well when you can sell investments with little or no tax to pay. If you have significant accrued gains, another idea could work without causing a tax hit on the sale of those investments.
Here's an example: James has $100,000 of non-deductible debt (his home mortgage in this case). He also has a portfolio of investments worth $200,000 with an accrued capital gain of $100,000 (if he were to sell this portfolio it would trigger a tax hit of $23,000 at a marginal tax rate of 46 per cent). James transfers his $200,000 portfolio to his holding company on a tax-deferred basis (using section 85 of the Income Tax Act) and in exchange takes back shares in the holding company worth $100,000 plus a promissory note for $100,000 (there's a reason for it being $100,000; speak to a tax pro).
James then borrows $100,000 from his bank and uses the cash to subscribe for more shares in his holding company. This use of the borrowed money allows him to deduct the interest on those funds. The company then takes the $100,000 of cash it receives on that subscription of shares and uses the funds to pay off the $100,000 note owing to James. There's no tax to pay on this repayment of the note. James then takes the $100,000 of cash and pays off his non-deductible debt. In the end, James still has $100,000 of debt, but he's able to deduct his interest. Now, as a practical matter James may not go to these lengths solely to create an interest deduction, but there may be other good reasons to put investments into a holding company. Speak to a tax pro for more.
"Fill the hole" to create interest deductions.
Last week I mentioned the importance of being able to directly trace the use of your borrowed money to an income-producing purpose. There are some exceptions. You can have your company borrow funds for the purpose of redeeming shares, returning capital to the shareholders, or to pay dividends. In these cases the interest will generally be deductible, because the borrowed money is really going to "fill the hole" left by the payment to the shareholders. That is, the borrowed money is replacing capital being used for purposes that would give rise to interest deductions.
Investing for growth is still generally okay.
You must have a reasonable expectation of income if you hope to deduct interest on borrowed money. Some would rule out investing in growth stocks as a result. In actual fact, the taxman will generally allow an interest deduction when using borrowed money to buy common shares as long as there's some expectation of future dividends, even if this is not likely in the foreseeable future.