While it may be snowing in central and eastern Canada, savvy investors aren’t thinking about shoveling their driveways—they’re considering ways to dig out from potentially limiting non-deductible debt.
Non-deductible debt is classified as any loan where the interest cannot be claimed as a tax deduction. This includes: mortgages on primary residence, credit card debt, student and car loans and personal lines of credit.
For the majority of Canadians the largest non-deductible debt we carry is our mortgage. And over a 25-year period most of us end up paying hundreds of thousands in interest charges.
In an effort to minimize the cost of this debt Fraser Smith, a B.C. financial planner, developed the Smith Maneuver. Simply put, this method of commoditizing mortgage debt worked by setting up a readvanceable mortgage (a mortgage that provides a line of credit that is directly proportional to the amount of equity you have in the home). Then by selling all non-registered portfolio holdings and using them as a down payment on the mortgage—thereby providing equity room—you were able to borrow from the readvanceable mortgage and invest this money, at a higher rate of return than the mortgage interest rate. Because you were investing the borrowed money you could deduct the loan interest and use your tax refund to pay off your mortgage faster.
But there were problems: the paperwork for the Smith Maneuver could get complicated, and no software or tax programs were developed to help ease this process.
Another option is to loan yourself a mortgage—a strategy even Garth Turner, the real estate cynic, suggested in his book The Little Book of Real Estate Wisdom.
In order to adopt this strategy you must first have an RRSP portfolio that equals or exceeds the outstanding mortgage owed on your home. Then you need to find a lender that will set up a self-directed RRSP. Once this is set up you can put the mortgage into the RRSP—consider it a fixed income portion of your portfolio holdings. Now, instead of paying principal and interest payments to the bank, you pay them to your RRSP.
To help illustrate this example, consider the following (adapted from Turner’s 2002 book):
- Start with a mortgage-free home, or have at least 50% equity in your home.
- Establish a $100,000 non-registered investment portfolio.
- Set up a $100,000 RRSP mortgage on your home.
- If your mortgage rate is established at 7%, then your monthly payment would be just over $700—and is a tax free transfer of equity from your home into your RRSP.
- By setting this up you have created a $100,000 debt paid to yourself over the next 25 years (the amortization of your mortgage).
- At $700 per month, with a 6% rate of return (before inflation) you will have contributed just over $485,000 to your RRSP in 25 years.
There are a couple of rules:
- You must pay the current posted rate as the interest rate on your mortgage.
- Your lender will use your home as collateral, in case you default on your mortgage payments.
Also, there are costs involved.
- An initial set up fee from your lender. Approximately $300
- Start-up legal fees. Approximately $500+
- Annual administration fees, charged by the lender. Approximately $200/year
- CMHC fees of around 0.5% of the mortgage principal (this is mandatory and a trustee will examine your payments annually to ensure you are not defaulting on the mortgage)
- Annual self-directed RRSP administration fees. Approximately $150 per year
While this sounds fabulous, you need to keep in mind the main goal of your RRSP: to maximize the rate of return so that your money can compound and grow for use in your retirement. These days, with rates so low, it becomes very difficult to use a self-directed RRSP to both create a deductible mortgage and to grow your retirement savings.
Keep in mind, as well, that mortgage payments to your RRSP are not RRSP contributions. That means those payments will not generate tax savings.
But, if you are an investor who is not solely relying upon an RRSP for your retirement savings, or you are a very conservative investor who is not concerned with maximizing annual tax rebates, the self-directed RRSP that holds your mortgage debt may be the ideal solution.