Cash Damming – Robbing Peter To Pay Paul (And Writing It Off, Too!)
In my last blog, I laid out the principles behind deductible interest, along with a few suggestions on how to organize your affairs so that you can increase the size of your tax refund to pay down your debts sooner. It is now time to up the ante and discuss some of the more advanced techniques available. Today, I’ll focus on a technique that is primarily used by unincorporated business owners: cash damming.
Cash Damming – The Basics
If you haven’t read my previous article explaining the basics of interest deductibility and how to calculate the true cost of borrowing after factoring in the tax benefits of deductible debt (the “effective interest rate”), then I suggest a strategic retreat until you’re up to speed on those subjects. Cash damming focuses on and exploits these rules to increase deductible debt that has a lower effective interest rate than your mortgage or other debts you can’t write off. It focuses on separating your business expenses from your business income, using your business income to pay down non-deductible debt and borrowing fresh funds to pay down business expenses. Even better, this technique is completely legal so long as you create the proper paper trail.
Although borrowing to pay business expenses requires increasing deductible debt in order to pay off the loans the business owners can’t write off, that’s just fine if the deductible debt has a lower effective interest rate than their mortgage. Ultimately, this strategy reduces the total effective cost of borrowing, which frees up more money to pay down debt and eventually become completely debt-free a lot faster. This two-step process first focuses on converting your mortgage to deductible business loans. Once this has been accomplished, the business owner can then focus paying down their business loans.
Needless to say, the Canada Revenue Agency (the “CRA” or the “tax guys”) weren’t initially in favour of what may seem to some as a bunch of smoke and mirrors. Fortunately for us tax payers, the courts sided with us when the CRA challenged this technique. At this point, not only has the CRA given up the fight against tax damming; they even have an “IT bulletin” (an interpretive document spelling out their view on various tax subjects) discussing the steps that need to be in place in order keep them off your back.
The key from the CRA’s perspective is keeping detailed records showing that the business expenses get paid from borrowed money rather than from business profits. It is generally recommended that the gross income from the business be accumulated in one account and the business expenses be paid from another in order to make it easier to track what is going on. The business person would likely have a separate line of credit or other loan devoted exclusively to business expenses that they can borrow from to pay down the costs of doing business.
For those of you that are still a little fuzzy as to how this all works, here’s an example that hopefully shines a little bit of light onto the subject. Imagine Peter is a businessman with a mortgage of $500,000 at 3% who lives in Ontario. He makes $200,000 per year from his unincorporated business in gross revenue (i.e. before expenses). As he has $30,000 in business expenses each year, including what he pays to his supplier Paul, his net revenue before taxes is $170,000. Let’s assume he lives in Ontario and that his marginal tax rate (the tax rate he pays on the last dollar of net revenue) is 46.2%. Since we’re making assumptions, I will also assume that the terms of Peter’s mortgage allow him to make an additional $30,000 per year in mortgage payments without penalty.
If Peter was like most businesspeople, he would pay the $30,000 per year he owes Paul and others out of the $300,000 in gross revenue he receives each year. That leaves $30,000 less each year to apply towards his mortgage. Instead, let’s assume Peter could borrow on a separate line of credit secured against his house at 3.5% that has a credit limit of $550,000. He has one account to receive his business income but pays Paul as well as his other business expenses out of another. This initially frees up slightly less than $30,000 more to apply towards his mortgage (noting that the interest rate is slightly higher on the line of credit than the mortgage.) At first blush, it may look like Peter is merely treading water or even losing ground since he has just replaced one type of debt with another that is at a higher rate.
Once he gets his tax return, however, the situation starts to change. Peter is able to deduct the interest he pays on the $30,000 loan. Because of his high tax rate, his true cost of borrowing is only 1.88%. That leaves him ahead by $486. The real benefits start to accrue in later years. Each year further into this strategy, more of Peter’s debt becomes deductible. Let’s assume that, by the time Peter has paid down his mortgage, he has accumulated $350,000 in deductible debt. After factoring in his tax deduction, Peter is ahead by $6,580 that year by paying interest on $350,000 at 3.5 in deductible interest compared to paying 3% on a mortgage balance of $350,000.
Of course, that example only tells half the story. Peter will have been able to pay down his mortgage far quicker that would have otherwise been the case by applying each year’s steadily increasing tax deduction against the mortgage balance in addition to the $30,000 freed up by borrowing to pay down the business debt. In other words, although he may save $6,580 in the year his mortgage is retired, the smaller savings in previous years will collectively compound to generate hidden savings that pay down the mortgage far sooner than you might think.
Moreover, the savings continue until the deductible debt is paid down as well; each year that Peter pays interest at an effective rate of 1.88% (3.5% interest combined with a tax rate of 46.2%) instead of 3%, he is even further ahead of the game. He might even apply for a new, completely deductible mortgage at that time to lower his effective interest rate even more and take away the risk of rising interest rates. The final win for Peter comes after he pays down the deductible debt as well. This comes from all the money that he would have been paying in additional mortgage payments under the original mortgage (and all the growth on that money) that he now gets to keep for himself!
If considering cash damming, I suggest keeping the following factors in mind:
- This strategy produces more savings in times of higher interest, when the deductible interest produces a bigger tax refund.
- ·Many businesses have higher expenses than quoted in my example and this strategy is even more effective for them. In such situations, cash damming works even better, as clients are able to create more deductible debt more quickly and get bigger write-offs sooner.
- There is definitely risk in trading a fixed mortgage for a variable loan even if it is deductible. Cash damming only saves you money if the effective interest rate on the deductible debt after factoring in the tax deduction is less than your mortgage. If the variable rate on your business loan climbs, then the benefits of cash damming shrink. Fortunately, it is usually possible to convert variable loans to fixed loans along the way. Once the original mortgage has been paid down, it is also possible to take out a new mortgage to pay down the business loan, which removes this risk while also getting you the lowest fixed rate possible.
- You will need to study the terms of your mortgage to see if it allows you to increase monthly payments or annual top up payments (or both) enough to fully maximize this strategy. If not, you might also need to determine the costs of breaking your mortgage, along with any increases in interest rates when taking out a new mortgage, such as an all-in-one or readvanceable mortgage that lets you take full advantage of cash damming.
- Don’t forget to pay the interest on your business loan each year, as otherwise it is not deductible. While it is possible to borrow to pay the interest (and increasing your deductible debt sooner), you may wish to keep things simple and just pay this expense from your business revenue.
- Many people need the help of an accountant or pay additional costs to set themselves up to cash dam, although many accountants don’t do cash damming as part of their business and may not be familiar with this strategy. Be sure to get an idea of these costs in advance before making your decision and to consult with someone experienced with cash damming.
- ·Although cash damming can be a great money saver, it is not the only way to reduce taxes. Be sure to also explore other options, such as incorporating, before committing. Besides providing creditor protection, a properly arranged company may be able to income split with a low income spouse and adult children. You will likely need to crunch the numbers to determine what works best for you. Even better, perhaps you can delay incorporating for a few years, such as if you have significant business expenses, and incorporate once all you debt is 100% deductible. In other words, why not have the best of both worlds? In some cases, clients with existing companies may even decide to transfer back to a sole proprietorship in order to cash dam before incorporating again in the future for this same reason.
Anyway, congratulations to those of you who have followed me through to the bitter end. To learn more about this strategy, I suggest talking to your accountant or an experienced financial planner. I also have a friend (Arnold Machel of Visionvest Financial in White Rock, B.C., who helped me with this article) who can provide more detailed calculations of the potential savings. For those of you that are interested in other deductible interest strategies, stay tuned for my next article: The Smith Manoeuvre – Cash Damming’s Aggressive Younger Brother.