Tax traps: the tourist
For every great customer that can benefit from your tax advice, there is also the trap to watch out for. The tourist is the first one of these, and it's the label we apply to multiple property owners who just can't stay put, insisting on changing their principal residences to one of their investment properties. At first blush, you wouldn't see anything wrong with this, but one needs to be careful.
Take the curious case of Nina Sherle. In a landmark court decision last year, Sherle, a dual homeowner, decided to do such a move. Prior to changing her principal residence to her investment property, she enjoyed the benefits of a tax-deductible mortgage on her investment property and her principal residence was free and clear. In an attempt to keep her situation the same as she switched houses, Sherle mortgaged her current principal residence and used the proceeds to pay off the mortgage on the current rental, then moved into the current rental and legally made it her new principal residence. Sherle proceeded to rent out the old principal residence, effectively turning it into an investment property and deducted the mortgage interest as before. The desired result was to end up in the same situation - a tax-deductible mortgage on the investment property and the principal residence free and clear.
The Canada Revenue Agency reassessed Nina on the basis that "use of proceeds" of the mortgage on the investment property was ineligible and the court agreed, the moral of the story being that regardless of good intentions, the legal effect of doing this without proper planning is to make your tax-deductible mortgage no longer tax deductible. (For a full explanation of this and to learn how to avoid such scenarios, visit the "mortgage professionals" portal at TDMP.com).
This term applies to accelerated Smith Maneuver and TDMP clients. Double-dipping, as you might infer from the name, is a big no-no under Canada Revenue Agency rules. It most commonly occurs when the homeowner invests in tax-efficient mutual funds for their mortgage strategy, the most common of these known as ROC (Return Of Capital Funds). ROC investments are very popular for advanced strategies because not only is the cash flow tax-efficient, it is consistent month over month, which mitigates cash flow risk and reduces the administration required in many debt conversion strategies.
The problem is that if an investment returns capital to the investor instead of providing some form of income, there is corresponding erosion in the tax deductibility of the original investment loan that has to be dealt with properly and reported to CRA. If this ROC distribution is used to pre-pay a mortgage (before being re-advanced and re-invested), CRA has advised that, even though the monies are ultimately reinvested, the initial use of proceeds (which was to pre-pay the mortgage) is ineligible for tax deductibility.
Homeowners in managed strategy programs will be covered for this situation as the calculations and tax reporting prevents inadvertent double-dipping. However, do-it-yourself Smith Maneuver clients will rarely go the trouble of making this calculation and tend to tax deduct everything, inadvertently or intentionally. As a mortgage professional, make sure your clients double-dip at their own risk - not at yours.
While most mortgage professionals should not be putting themselves out there as tax experts, it is prudent to have a decent background and understanding of the tax implications of a mortgage transaction. All homeowners should be encouraged to employ a tax professional both in planning complex transactions and for filing tax returns. However, such advice comes at a price that may deter some borrowers. Having a keen eye on the mortgage transaction and advising customers of potential tax advantages and pitfalls is a welcome service.
- Sandy Aitken is founder and CEO of TDMP.com, which provides managed Smith Maneuver and
Tax-Deductible Mortgage Plan (TDMP) services to homeowners. These advanced mortgage strategies are distributed exclusively through independent mortgage professionals, and the company offers Certification training, marketing and sales support to mortgage agents through its website.