Beware of the Tax Deductible Mortage

A few months ago I met a new client looking for financial planning. We sat down together and discussed planning philosophies, directions she wanted to take her business and what she would like her life to look like in the future. Once looking at her situation I realized that all of her investments were leveraged against her home. Several years ago she was convinced that she needed more tax deductions and that her mortgage was a "bad" debt that could be turned into a "good" debt by setting up a tax deductible mortgage (TDM).The TDM or “Smith Manoeuvre " as it is colloquially known, is a way to turn your mortgage debt into a tax deductible investment loan. Because mortgages are not tax deductible in Canada, this is a way to restructure your mortgage into a line of credit (LOC) secured to your home. You then borrow money from the LOC to buy an approved investment. When purchasing an investment from borrowed money (leveraged investing) you are allowed to deduct the interest cost from the loan off your taxes. A TDM is different from a typical investment loan in that you never pay down your debt, but add to it. As the principal from your mortgage shrinks, that difference is transferred to your LOC. As your LOC increases you take that difference, invest the money and the investment in theory will pay the interest. According to the people who sell the scheme, your "bad" debt (not tax deductible) has been transformed into "good" debt (tax deductible). Like an extended warranty, how can you lose?Let’s take a look some of the issues many people face with TDMs.

1. The idea that there is such a thing as "good" debt. While debt is a fact of life for many of us, the only good debt in my opinion is the one you don't have.
2. Another issue with a TDM is how complex they are to set up and that comes with a cost. In my client’s case, her expenses increased by $5,024/year, even with the tax savings. There are also many hidden charges.
3. Often the people involved only understand their part of the structure. The lending institution doesn't know the cost of the investments, the financial advisor doesn't know what the set-up costs are from the lender and no one calls the client’s accountant to see if there are better options to find tax efficiencies.
4. If your investment goes down it won't be able to pay back the loan if needed.
5. In most cases deferred service charge (DSC) mutual funds are bought. If you ever need access to your investment, you are charged the DSC upon selling which can be as high as 5.5%. This can really hurt if you have to sell your investments to buy another home. This brings us to…
6. What happens if you sell your home? Your home needs to be equal to or greater than the loan value. If you decide to move (or worse, forced to move), are you going to have the down payment for your next home? Also, there might be penalties if you pay your loan off early.

At the end of the day, leveraged investing such as TDMs need to be very carefully considered. A great deal of homework needs to be done by the investor to make sure this is an appropriate way to save and invest. Always consult with your financial advisor and your accountant to make sure it's right for you. In 10 years as a financial advisor, I personally have never come across a circumstance where setting up a TDM was beneficial for my clients. Yet there are seminars held across the country that continue to aggressively push TDMs as a way to save. I will fully admit my bias and say most people should avoid this type of investment structure; the potential costs, market volatility and hidden fees are simply not worth risk to your home or financial situation.After months of homework and careful consideration, I helped my client wind down her TDM and we are now moving ahead with a proper financial plan that will be tailored to suit her specific situation. This is not to say if someone is in a TDM that it should be just shut down. Anyone who has taken first aid knows you don't just yank a knife out of the patient as you may do more damage. Depending on how a TDM was set up, the structure may have to collapse differently than from someone else or it may not be appropriate to wind it down at all. Professional advice is essential.