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My advice • May 14, 2020
modified on May 22, 2020

Investment Series - Reorganizing your loans to make them tax-deductible: a strategy worth exploring

Rethinking your financials may be beneficial but it’s not an option for every investor. Here are a few tips on how to do it.

Pierre-Raphaël Comeau
Expert Advisor, Wealth Management
and Financial Planner
LBC Financial Services

You probably already know that mortgages, personal loans and credit cards are expensive when you add up the interests you paid spread over years and the minimum payments you need to make to repay them. What if, in some cases, reorganizing your loans could help you improve your financial health?

It’s in your best interest

As a first step, you have to take a look at your personal finances and create structured balance sheet. First, list your assets, which include, among other things, money you have in your chequing or savings accounts, your RRSP, your TFSA, your non-registered investments, your employer’s pension plan and any property you own like a house or cottage. Then, list your debts: credit card balances, lines of credit, personal and car loans, mortgages, student loans or any other loan.

Once you’re done, look at your non-registered investments and debts. Would you be able to pay your debts using your non-registered investments? If that’s the case, you can pay off your debt with your non-registered investments to free up liquidity and reduce your interest burden.

This strategy is known as “debt restructuring”

It’s generally used over the long term, a consumer debt (credit cards, line of credit, etc.) is transformed into a productive debt (that generates interests) that is then tax-deductible. To do so, you need to pay this debt with your non-registered investments and then borrow the same amount to buy back investments (using an investment loan) in a non-registered account. This will reduce your tax bill as interest paid on a loan used to earn investment income is deductible.1

A word of warning for this strategy. It requires that you understand the risks associated with this leverage effect.

To use this strategy which involves investment loan, you must:

  • Have loans with non-deductible interests
  • Have non-registered investments (e.g., not RRSP or TFSA)
  • Have good risk tolerance
  • Aim for long-term goals
  • Anticipate that your investment will earn you more than the loan’s net cost
  • Be in a strong financial position
  • Be prepared to meet the loan’s obligation even if the value of your investments falls below your loan’s balance
Converting a personal loan into an investment loan

Here is an example to help you better understand the details of this tax tango.

Converting one type of loan to another is not a decision you can make without the advice of an expert. We recommend that you talk to your tax advisor to make sure it’s the right option for your specific situation.

Let’s use Francis’s car loan as an example from the Five tips to not pay more than your fair share of taxes article.

Francis is a balanced investor, he has been investing for over 10 years and has a good understanding of the investment world.

A $30,000 Car Loan

  • The interest on his car loan is not deductible because he borrowed to buy a car.
  • Francis may choose to change it as follows:
    1. Use his non-registered savings to pay back his car loan.
    2. Borrow another $30,000 using an investment loan.
    3. Use that $30,000 to replace his savings with a long-term investment.

Conclusion: The loan amount is the same, $30,000 but the interests are now tax-deductible since the investment loan is used to accrue income from his investment.

In both final situations, Francis has the same assets: a $30,000 car, a $30,000 loan and non-registered investments totalling $30,000. It’s just that the acquisition order changed, but it results in significant tax savings.

A borrower needs to understand that since the loan tied to an investment, its risk is tied to the market. In concrete terms, investors need be able to cope with their investment losing value and remain responsible for a loan with a $30,000 nominal value. Good risk tolerance and market knowledge are key to reap the benefits.
What about the government?

There are nuances in how this strategy is handled between the different levels of government. At the federal level, you can deduct the interest on the investment loan regardless of what you have generated as investment income during the year. At the provincial level, you can deduct the interest, but only up to what you earned in investment income for that year. The interest balance can be deducted later when more investment income has been generated. However, note that the interest on the loan is deductible as long as you have the investments. When you sell them, you will no longer be able to benefit from the deduction in this strategy.

First, talk to your advisor to find out if a debt restructuring strategy may be financially advantageous for you. They’ll do a financial health assessment and give you advice based on your financial situation, risk tolerance and priorities. They will point you to a tax expert, if needed.

A Financial Health Assessment is the first step to better manage your personal finances. It helps paint a clear picture of your financial situation, define and prioritize your objectives, and suggest what you should do. Take your first step now and meet with your advisor.

 

 

1. Under certain conditions. Please consult your tax advisor for more details.

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