Home Equity Investment Loans – Leveraging The Loonie Bin For Income Splitting

I recently did a post on leveraging your home equity to invest and building the taxable account of a lower income spouse. That strategy is part of intermediate-term income splitting.

Whether using an investment loan against your home to fund investing is a good idea or not depends on multiple factors including:

  • Whether a taxable account is needed as part of your investment plan.
  • A risk/benefit analysis.
  • Structuring the loan and payments to avoid triggering the attribution rules.
  • Investing to make the interest paid deductable against income.

We examined each of those points in detail in my last post but today we are going to look at a real life example. Ours.

I made the classic doctor mistake of buying a bigger house than necessary. It is castle-like and marginally smaller than the one in the photo. However, it feels about that size when it comes to cleaning, heating, and maintenance. On the other hand, we do use pretty much all of our space. Having multiple washrooms is handy more often than you’d think.

This was not our first home and we had been aggressive savers for a number of years before we bought it. We did take out a mortgage for about half of the house value when we bought. Having an ingrained abhorrence for debt, we aggressively paid that down.   Back then mortgage rates were about 6%, so it was like a 6% guaranteed tax-free return on investment.

However, we reconsidered this approach when our mortgage came up for another renewal a couple of years ago. With the low interest rates, our registered accounts filled up, and the threats of “making rich professionals pay just a little bit more” looming on the federal election campaign trail – we decided to revisit our approach.

Is a taxable account helpful to us?

We max out our TFSAs and our RRSP each year. We have also have significant retained earnings in our CCPC. With recent changes passive investment income taxation in professional corporations, we will likely surpass the allowed threshold before I retire. Other than our castle, we live beneath our means and prioritize saving to have extra money to invest each year. The new rules are more likely to affect those with high savings rates.

My wife makes a fraction of what I do. With spousal income splitting via dividends getting difficult, income splitting in other ways is important to us. We also plan to scale back and retire well before age 65 when income splitting of investments becomes much easier.

All of these factors mean that having a taxable account is a useful part of our investment plan. Further, to have it in her hands was the most efficient way to diversify our accounts and accomplish that.

What was our risk/benefit analysis?

At the time when we were considering our approach, we had paid down our mortgage to about 1/3 the value of our home. This meant that we had built up considerable “home equity”. We all need a place to live and home equity makes you feel rich. However, until you access that money, it doesn’t do you much practical good.

We examined three options:

  • Renew the mortgage at the same balance and continue to pay it down.
  • Renew the same mortgage and open a home equity line of credit (HELOC) on top of that.
  • Get a new mortgage for a higher amount and take the difference as cash.

The short and long-term borrowing plan.

The interest rates at the time for mortgages was 2.396% for a five year fixed term. We figured that we could easily beat that with investment returns. So, we decided to tap some home equity for investing. We decided to remortgage rather than use a separate HELOC. An ultra-low fixed rate was available and even as rates rise over time a mortgage is still one of the lowest cost ways to access money for leverage.

We remortgaged for $340K above the remaining balance. Even though we could have taken out an even larger mortgage, we decided not to. This amount gave us plenty to invest.

It also is locked up for five years and has some limits for repayment. So, that helps enforce investor discipline upon us. We could make some pre-payments. That would involve more effort on our part and have to be spread over multiple years. The best results when using leverage with unpredictable returns and interest rates is over long time periods. That makes barriers to deviating from the plan important. Conversely, it also means that you need to make sure that you are 100% committed and 100% comfortable before engaging.

How did we structure the loan?

When we took out the new mortgage, the difference between our previous balance and the new mortgage was paid by the bank as a cheque in my wife’s name and deposited directly into her personal account. Even though our mortgage was a loan to both of us, with our house as collateral, that portion went straight to her directly. This is functionally the same as having a joint HELOC (a loan accessible to both people with the house as collateral).

Attribution rules when using a joint HELOC.

For the purposes of attribution of income earned by the investment loan, the key factors are:

  • Who actually takes the money
  • Who actually pays the interest on it.

So, in this case, the money went directly to my wife. She pays her portion of the interest ($687.10) every month from her personal account for an annual interest cost of $8245. She made her first interest payment one month before we started making mortgage payments from our joint account. So, there could not be a case made that I loaned her money for the few days lag between her payment and our mortgage payments each month. We have kept records of the initial deposit and all of the payments to have a clean paper trail.

How did we invest the money?

My wife transferred the money directly from her bank account to her taxable investment account and purchased investments that pay some eligible dividends and are expected to make capital gains. Capital gains are generally the most tax efficient investment returns to have in a taxable account. However, you need some investment income via dividends or interest to be able to deduct the loan interest as an expense.

She purchased a mixture of ETFs:

The projected plan for investment income.

So, she would make ~7K/yr in eligible dividends and ~4K/yr in foreign dividends. She can deduct the loan interest of $8245/yr against her combined investment and earned income. This made for a net increase in her income of $2855/yr after taxes. With the eligible dividend tax credit and her marginal bracket, her tax bill is actually reduced by $800/yr.

She invests all of her income while I pay for our other living expenses from my income. I also pay any tax owing that she may have (paying someone’s taxes does not cause attribution problems). This allows us to maximize the growth of her taxable account.

Our results so far (very early days).

The above growth of about $3700/yr (investment income and tax refund re-invested) also does not account for capital gains growth. We try to avoid triggering tax events by deferring the realization of capital gains. So far, in the one and a half years that we have had the loan, we have total capital gains of $57K.

So, with a $344K loan, we have reduced our household tax bill by $800/yr. After two years (Oct 2018), we did some shuffling. We have had $20K in realized capital gains that we were able to defer tax on with some tax loss selling. There is still $47K of unrealized capital gains and we have had $20K in income. We have paid $16K in interest.

These are early days and we have had a couple of really good years in a row. Our results to date are a bit atypical. I anticipate fluctuation and lower returns over the long-term.

Having a high net worth is mainly useful for the fact that you can access the money to spend.

However, you usually have to pay tax when you access it. Having these investments in my wife’s hands means that it will be taxed at her lower rates when we do access it.

For comparison, if we had invested the same amount in the same securities in an account attributed to me, then our household tax bill would have risen by $550/yr ($1350/yr more than with her investing). Plus, any realized capital gains would be taxed at 27% in my hands instead of 15% in hers.

How could this strategy compare to other strategies over the long run as more typical returns and interest rates take hold?

To figure this out…. I made an Excel-based Investment Loan Calculator with built-in tax calculators for all provinces etc. Surely, you are as excited as I am [insert nerdy laugh and snort here].

I plugged in our salaried incomes, loan amount, estimated investment returns based on the longer-term historical performance of the above securities (or similar ones).

Everything is converted into “current dollars” by using an estimated average inflation over the next 25 years of 2%/yr. Getting results in “current dollars” does not have the wow factor of the huge “nominal dollars” amounts. However, I have an easier time understanding current dollar buying power rather than the seemingly huge “nominal dollars” that will actually have less purchasing power in the future.

I think that interest rates are likely to rise back to a more normal range, so I also put in different rates in 5 year blocks. The inputs are illustrated in the screenshot below.

Interesting points from the above modeling:

The average investment income (not even counting the capital gains) more than pays for the loan interest.

Even with interest rates doubling in about 5 years (years 6-10 in the above scenario), there is enough growth in the annual investment income to almost completely absorb that increased interest cost.

Getting a head start while interest rates are low makes this strategy more attractive.

Waiting until rates are already back to the longer-term normal is still viable, but not as good. If you were to start this strategy when mortgage rates are at 5%, then you would need to pay about $5K in interest above the investment income. That would be easy to do by realizing some of the $18K/yr capital gains or using some of her earned income. It would take almost 25 years for the investment income to cover the interest cost completely. That may still be worthwhile for some people. However, it is not nearly as good as starting with lower interest rates and is a higher risk maneuver due to the increased leverage costs.

So, what could this look like after 25 years?

I am assuming in our example, that we make interest-only payments during the 25 year period and then pay off the loan after 25 years.

Over that longer period of time, a number of things happen:

  • The loan never gets bigger, but it becomes easier to pay off down the road since inflation erodes it away. At 25 years at 2% annual inflation, the $344K loan would be equivalent to $208K in “current dollars”.
  • The interest drag from the loan relative to the investment returns becomes less over time as the loan stays the same in size while the portfolio increases in size. It starts as 2.4%/yr drag on returns and is 1.8%/yr by the 25th year.
  • The portfolio increases in size due to the compound gains. At the end of 25 years, it would be worth >$1M in nominal dollars or $550K when adjusted for inflation. After we pay back the loan, that would be $343K that we otherwise would not have had if we had simply let our home equity sit without putting it to work for us.
  • As the portfolio income grows, so does my lower income spouse’s income. That could bump her up tax brackets. In this example, since my wife is in the middle of a wide tax bracket, it actually does not happen and the tax drag on returns in her hands is ~0.5%/yr.
  • For comparison, if the same loans and investments were in my highly taxed hands, the account would only be worth $153K after adjusting for inflation and paying back the loan balance.

The benefit of attribution to a lower income spouse at the time of withdrawal.

When we go to actually access that money, the fact that it would be taxed in my lower income spouse’s hands makes the difference even greater. Let’s say that we draw down on our accounts with accessing some RRSP for her and corporate dividends for me as per below.

mortgage interest tax deductible

After taxes, we would have an extra $13K/yr retirement income because we used this strategy compared to if we did not leverage our home equity to invest. In terms of income splitting, using this strategy with my lower income wife gives us an extra $8K/yr income compared to if I had invested and then accessed the funds in my own name.

How could this investment loan income splitting strategy apply to your own situation?

Hopefully going through my own case was illustrative by attaching some real numbers and the considerations in our case. I realize that we are very fortunate financially and that this would look different for different people. You can try using your own income, interest rates, province, and guess at investment returns and inflation in the investment loan calculator to get a rough idea like I did.

Of course, it would also need to fit with your overall financial situation and comprehensive financial plan. I would suggest finding a good accountant to advise you if considering this strategy. I ran this past mine before making any moves.

Originally posted March 7, 2018. Updated & Reposted Nov 24, 2018. I was inspired to re-examine and repost this one because of a couple of great posts about paying off debt vs investing (outside of the income splitting slant) by FFMD. A common dilemma and he has an analysis here with interest/return stress testing here.

25 comments

  1. Hey LD

    This is crazy that you haven’t received a single comment on this great post!
    It is fascinating to me the amount people will borrow to purchase their home, but will generally scoff if you talk about borrowing to purchase income producing assets on non margin low cost debt.

    Needless to say this is something I have significant experience with and will be working on some posts that try to rationalize the approach for a risk tolerant wealth accumulator.
    The income splitting concept was interesting – I have never looked at that angle since my wife and I share our corp.

    Look forward to more of your posts!
    FFMD

    1. Thanks FFMD! I think many let the emotional aspect of home ownership plus the recency bias of unusually large price gains make them irrational in thinking about home equity and mortgage debt. It is still debt and home equity doesn’t do you any good unless you make it work for you.

  2. Really interesting post. I guess this strategy may even be more optimal if there is still tax sheltered accounting space available (i.e. TFSA and RRSP room at the time of mortgage renewal)

    1. Hi ZC and thanks for the comment. If using leverage to put money into a tax-sheltered account because there is extra room, that does help top up those accounts. They can then grow tax-sheltered over a longer time period. FFMD’s analyses are great for looking at the math of that dilemma.

      However, it also means you can’t deduct the interest. I took a slightly different angle in this analysis because it is a taxable account. Also, the math can change if you are using the leverage to invest in a taxable account and have a personal high income. The income tax drag plus loan interest can become significant in higher marginal brackets and eventually exceed returns.
      -LD

  3. Hi LD:

    Good post! Is this a variation of smith maneuver? I think the potential risk is with a slowing market and rising interest rate.

    In terms of income splitting, I think you just need to cover your wife before 65 as splitting is allowed after. With your anticipated nest egg and relatively low expenses, you could withdrawal capital gain @25% from your corporation. I wonder if this is most tax efficient way to get rid of excess saving corporately before 65 and still qualify for your OAS benefits (admittedly not much in the grand scheme)

    1. Hi BC Doc. There are some similarities to a Smith maneuver, but a bit different. A Smith maneuver is more dynamic in that you are constantly decreasing the mortgage amount and increasing the HELOC to gradually shift to have a taxable investment account and a tax-deductible “mortgage”. This was more a one-shot move because it fits our situation. A couple of minor differences. We don’t use the investment income or tax savings to pay down the loan. We are just letting the account grow as part of our overall plan. That way it becomes an income stream for my wife. We also may not increase it at the next renewal.

      The main threat, as you say, is rising interest rates on the loan at renewals. We got such a good head start with five years of low rates that we can tolerate some of that for a while and are likely to downsize in 10 years or so. We also have the resources to cash out and change strategies at any point before then. Using some leverage when you have plenty of resources to pay off the loan is less scary.

      For us, income splitting before 65 is important. We may retire as early as 50 and will likely continue to spend pretty significantly. So, having the extra pot to draw from helps us. We are a bit unusual in the mix of early retirement and big spending. Most people have to compromise with one or the other.
      -LD

  4. Great post. Spouse has high income also, so we haven’t used this strategy. Looking at the list of assets, you list VEE twice. Is this a “typo”? Or did you acquire 2 lots in which case you can just use the average cost base.
    Would love to see posts from people outling their asset allocations and asset locations.

    1. Hey Crazycardio. It was two lots. I probably should just combine – I was lazy and just copied/pasted 😉 My overall asset allocations and locations have shifted over the past year as I have learned more and have shuffled to adjust to the new rules. I will give more on that at some point – a work in progress.
      -LD

  5. Hi LD. I always enjoy your posts.

    I think buying on margin is great when times are good. No one wants to be upside down, whether in an investment or especially regarding your home. I bought on margin once and it was only $10 k. Getting that call from the broker for more money due to market declines was the best advice I ever got. Taking out $340 k against your house is very ambitious given the potential for a 20% market correction and rising interest rates.

    For me, I’m too risk adverse for this. I still remember the day my mortgage was paid off. Having no debt is great for us. I appreciate you running the numbers, but may I suggest also more focus on the downsides.

    Cheers.

    1. Hi JBB. Those are excellent points. I touched on the downside considerations a bit in another post. I perhaps should have avoided numbers in this one. My intention was to be concrete and transparent when I wrote it, but it probably gives the wrong impression. The $340K is a big number. However, for us it is about 1/3 of our mortgage and our mortgage is well under 50% of our house value. We also have a large accessible investment portfolio. If the loan were called, we could pay it without too much fuss. This maneuver would likely have to be on a much smaller scale for the average person.

      Leverage is something to only use carefully and specifically. Considering the worst-case scenarios is key if considering it. We have avoided it in the past. However, we are better positioned to deal with it now than in the past and the income splitting angle tipped us in favor. Leverage magnifies gains and losses. Thinking about the potential losses and knowing you can stomach it is vital.

      I would specifically avoid leverage if:
      1) It has become popular. When everyone is thinking things are so awesome that they leverage for more, it makes the contrarian in me squirm. Things move in cycles and are most popular near the peaks. The best time to consider leverage is if the markets are terrible and times are bad – except you personally have a strong financial position.
      2) I was just learning to invest. I will for sure make mistakes and best not to magnify the impact.
      3) I would be forced to sell something (like the investments or my house) to pay the loan back. You can be forced to repay loans at inopportune times if it is a callable loan (like a HELOC or margin account), you sell your house to move (mortgage), or you have difficulty renewing because of market declines.
      4) If I have a short-term investment time horizon. Short-term is usually speculating and risky. Leveraged speculating is super-risky.

      Those are the ones that jump to mind. Also, as you point out, being debt-free is great. I have never heard anyone regret that.
      -LD

  6. Hey LD,

    As you know I keep it simple. If someone else pays for the loan eg cash flow positive real estate, I’m all in. If I am on the hook for paying the loan- forget about it.

    I can not keep up with all the machinations of these manoeuvres. The whole point of money for me is to NOT even waste bandwidth thinking about these things.

    I know many people enjoy thinking about these things. I am not one of them. It all goes back to “know thyself”.

    But excellent post for others thinking of this however.

    1. Hey Dr. MB. The main effort for us in this one was analyzing our situation and deciding to do it. My wife’s pay is automatically put into her account and her loan payments are automated also. The investments just sit in her investment account. We copy and paste her bank statements annually for the accountant to deduct the interest in doing her taxes. We also keep a copy in a folder along with the original transactions for the loan deposit and investment purchases. So, not as bad as it sounds. We spend about 15 minutes per year on it.
      -LD

  7. Haha LD!

    That’s my point exactly. YOU could pull this off seemlessly. I, on the other hand, would most certainly find a way to FORK IT UP. I am not kidding, it would just happen.

    I have experienced moments like this too often to pretend that it would not happen to me. Insight is so valuable when you are as old as I am.

  8. You’re playing with fire. Putting your home at risk to try and make some extra money you probably don’t even need. I wish you luck and hope you don’t get burned. My philosophy is to stop managing debt and start eliminating it. It’s a lot safer.

    Dr. Cory S. Fawcett
    Prescription for Financial Success

    1. Hi Dr. Fawcett,

      I agree that eliminating debt rather than managing it, in general, is a good philosophy. I have never heard of anyone regretting that.

      In my case specifically, it is more of a way to spread out our income and assets between my wife and I. In Canada, our mortgages are not normally tax deductible – this move changes that. Plus, we are also taxed as individuals rather than households. In my hands that means 54% marginal tax rate. In my wife’s hands, it is 20-25%. Those two factors changed the risk/benefit profile for us. Plus, we are not really risking our house. We trashed debt aggressively long before this. The investment loan is about 15% of our house value and the other portion of the mortgage about 25%. We also have separate funds available to pay it all off tomorrow, if needed. The bigger issue for us was that we had too much of our money tied up in our house. We needed to both diversify that and spread out our wealth more evenly between my wife and I.

      We have done really well with saving overall. So, you are right that we don’t need to take on risk to amass more money. We do, however, need to have it organized in a way that allows us to access it tax efficiently. Unfortunately, the Canadian tax system is set up to make it difficult for large income single-earner households to keep money. Especially, if they try to save more than $30K/yr for retirement. We are taking on some calculated risk and complexity because of that.

      I don’t think I’ll regret our move, but hopefully, those aren’t famous last words! I would also say that anyone considering this type of move needs to carefully consider their risk/benefit profile. Using leverage to invest is playing with fire. It would likely not be favorable for the average Canadian household. However, it may be for a high-income high-savings-rate single-earner one.
      -LD

        1. Hey BC Doc! If I follow the career “script”, that will definitely be a problem. I am actively trying to recalibrate to rectify the issue 😉 My basic game plan: work less, spend more, give more. I just want to make sure that my wife and I get to decide where to give rather than the government.
          -LD

  9. I totally get it LD. The biggest challenge may be how to average the tax if retirement starts before age 65. This approach helps. I like the numbers 25 years down the road. Would I have the resolve to keep this position for that long? Who knows. Currently we have enough freedom with salary and dividends that building my non registered portfolio doesn’t seem overly restricted. I have run the numbers for us with straight up paying the mortgage down or investing in non reg and with the last rate hike we have began extra mortgage payments. With your example adding in the ability to deduct interest would increase the debt repayment balance point. I’ll play with the calculator and see what results! Perhaps the future may open this option up if we are running into tax walls.

    Thanks for sharing this LD.

  10. This is a highly sophisticated strategy, LD, on the order of GoCurryCracker in its brilliance.

    I’m dazzled by the care you’ve invested in crafting a low-risk (but not no-risk) use of leverage to optimize tax minimization.

    Not to undervalue it, but would your wife be able to continue the strategy and keep all the plates spinning in the event of an unexpected barrier to your personally continuing to manage it?

    I am but a simple caveman, and such strategery is beyond my “majesty of simplicity” approach to FI…but I still enjoy the financial voyeurism of watching stars brighter than my own.

    You can be Hi-Fi, and I’m content to be your Lo-Fi admirer.

    With admiration,

    CD

    1. Hey Crispy Doc. Great points. I think that complexity and succession planning are very important issues.

      My strategies three or more years ago were all very simple. Work hard/efficiently, trash debt, max out all tax-sheltered accounts, and leave the rest invested through my corp. Unfortunately, our tax system here is super-complicated and becoming even more so. Our government here keeps making more rules to target more revenue while avoiding politically important groups. Each time that adds complexity. Those in the large demographic groups (even amongst doctors) are generally fine and a simple strategy is best. However, if a doctor here deviates from “the script” too much here by earning too much, saving too much, or retiring before age 65 – then tax planning becomes a major issue.

      The biggest complexity for us in this strategy was in actually carefully considering the risks/benefits and then the set-up. The strategy is now on auto-pilot. Plus, my wife actually updates our investments and does all of the book-keeping for our business. We also review our budget periodically to make sure we haven’t gone off the rails. She even tolerates reading my blog. So, she (begrudgingly) has a pretty good understanding.

      Regardless, if something happened to me, then we would simplify. That would be relatively easy since I would no longer be working and need to worry about income tax per se. We also have a back-up plan through a good relationship with a financial advisor, our accountant, and an estate planner (if catastrophe). Those professionals come at a cost. However, we would have more than enough to look after our family and obligations and the last thing we would want is our family having to sort through it all.

      -LD

  11. Great post. This is a strategy that I use for many of the reasons you have alluded to. I would suggest anyone considering this carefully stress test possible outcomes. I would also suggest waiting for a recession before starting at this point 🙂

    One issue to consider. The use of ETFs is a great way to diversify simply. However, the “dividends” from ETFs often contain return of capital. When this occurs, I believe you will need to pay back the loan for the same amount as the ROC, or the CRA may be able to disallow the deduction of loan interest. Perhaps this is not an issue with a loan structured as a mortgage (mine is structured as a HELOC currently).

    I find it interesting that many people are ok taking out a large loan to buy a rental property, but feel that what you are doing is too risky. To my mind, you are essentially becoming a “dividend landlord”.

    Best of luck, and keep the great posts coming.

    1. Hi William. Great comments! It is good to hear of someone else doing this. I definitely agree that you want to “stress test” before considering any type of investing with leverage. An investment horizon needs to be long and you have to be able to weather the ups and downs without deviating. Difficult without a large buffer. I also agree that a rental property is basically another way of leveraged investing.

      If you receive ROC, then you may need to reduce the amount of the loan interest that is deductible as an expense. If the ROC is less than income received via income/dividends, then it does not. If it exceeds that income amount, then the eligible loan amount is decreased by the amount exceeded. I don’t think the amount of ROC from most ETFs would do that. However, some REITS are known for this way of distributing funds out. There are some specialty corp class mutual funds that also pay out as a return of capital.

      The time where this issue of ROC can really be important is if you realize a capital gain and want to take it out to spend it. If you realize a capital gain and re-invest it to earn more income, that is ok. Again, if the amount of capital that you take out exceeds the income earned (dividend/interest), then you need to reduce the amount of the loan interest eligible for deduction proportionally. For example, if your investments bought with the loan have produced $10K in dividends so far and you realized a capital gain of $12K and took that out to spend. Then the interest on $2K of your loan would no longer be eligible for deduction. This realizing of capital gains and taking that money out rather than re-investing is where the complex pitfall is. That is my understanding of it.

      Thanks for stopping by and great comment!
      LD

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