Jordan Tarasoff May 23, 2023 Personal Wealth Buying a New Home and Renting Your Old One: Don’t Make This Mistake You have a paid off or nearly-paid-off home that isn’t quite meeting your family’s needs. The back yard is cramped, there isn’t a room for the baby on the way and a bigger garage would be nice. Rather than selling your current home to upgrade, why not borrow against your current home to buy your new home and rent out your old place? You have heard that the mortgage on a rental property is tax-deductible. That should help lower your costs, right? Enough clients have asked us this question that we needed to clarify: In the above scenario, you cannot write off the mortgage interest. What does “write off the interest” mean? In many cases in Canada, when an investor borrows money to invest and generate taxable income, they can deduct the interest from their income for tax purposes. Say you borrowed money to buy equipment to start a business or to invest in a portfolio which pays some interest and dividends. Both activities are expected to generate taxable income. If you borrowed $10,000 at a rate of 5% on January 1st, at the end of the year you would have paid $500 in interest. When you file your tax return you get to deduct $500 from your income. This will either lower the amount of tax you owe or generate a refund equal to the amount of the deduction times your tax rate. If your tax rate is 30%, that means you reduce your tax bill by $500 times 30% or $150. The net, after tax cost of interest was only $350 or 3.5% ($350/$10,000) after you include the tax refund. This is one of the reasons why debt to fund investments is often called “good debt”. The after-tax cost of the debt is lower than if it was used to buy things for personal use and in theory, the what you buy should grow faster or pay more than the interest you pay over time (otherwise why would you borrow the money?). Write offs for rentals A rental property is also an asset which is expected to generate taxable income. That means when you borrow funds to purchase a rental property, in addition to property taxes and maintenance costs, you can write of the interest on your loan. This is the case whether you take a home equity line of credit against your home or use a traditional mortgage. If you have a new home, a loan, and a rental in the initial scenario, then why can’t you write off the interest? It’s what you buy, not what you borrow against In the initial scenario you are borrowing to buy something you plan to personally use and consume, your family home, not something that will generate additional income. It doesn’t matter that you are borrowing to keep a rental property, what matters is what the funds from the debt purchase. Even though the debt is secured by a rental, it wasn’t used to buy the rental. This means that you cannot write off the interest. When you look at the interest cost, you must consider the full amount as there will not be a deduction. Workarounds There is an expression “don’t let the tail wag the dog”. What this means is don’t let something small, like the ability to write off interest, dictate how you structure the big thing, the dog, how you structure your investments. The examples below are to illustrate how to have debt with interest you can write off while maintaining the same risk level and balance sheet. Sell the home and buy a new rental. Instead of keeping your current home to rent out, you could sell it, use the proceeds to buy a new home and then borrow against the new home to buy a rental. This fulfills the requirement of the debt being used to buy an asset that generates income. You have a home, a rental, and a debt, same as before. The downsides are that you will pay transaction costs on selling your current home and buying a new one. You may or may not buy a property that makes a better rental than your original home. Sell a portfolio, buy a home, borrow to replace the portfolio.This assumes you have a taxable investment portfolio sufficient to purchase a new home. If you sell the portfolio to buy the new home and then borrow against your rental to re-purchase the portfolio, that satisfies the ‘borrowing to earn taxable income’ rules provided the portfolio is expected to yield some interest/dividends. There are several downsides here. You may be triggering gains in your portfolio prematurely in order to sell and buy the home. If you are triggering losses, you cannot purchase the same investment within 30 days otherwise the loss will be denied. It is also more difficult to get approved to borrow to purchase a portfolio than it would be to purchase real estate – this is the nature of the Canadian banking system. The Take Away This situation is common enough it warrants an explicit statement: when you borrow to purchase your personal home, the interest is not tax-deductible, regardless of whether you use an investment as collateral or not. There are ways to restructure assets to improve tax-efficiency but often downsides to do so as well. You should never accept a sub-optimal investment strategy in pursuit of a tax advantage. Share: Facebook Twitter LinkedIn Email CIRO Advisor Report
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