The tax law for Canadian homeowners is very different from the system in the United States. One of the most notable differences is the tax treatment of interest on mortgages for a principal private residence. For homeowners in Canada, this interest is not tax-deductible. But any capital gains that a homeowner realizes when they sell the home are tax exempt.

But there is a way Canadians can effectively deduct that mortgage interest. This strategy involves increasing your assets by building an investment portfolio, decreasing your debts by paying off your mortgage faster, and increasing your cash flow by paying less tax. Effectively, you would increase your net worth and cash flow simultaneously.

How to Create a Tax-Deductible Mortgage Strategy

Every time you make a mortgage payment, a portion of the payment is applied to interest while the rest is applied to the principal. That principal payment increases the equity in the home and can be borrowed against, usually at a lower rate than you'd get for an unsecured loan.

If the borrowed money is used to purchase an income-producing investment, the interest on that loan becomes tax-deductible. This makes the effective interest rate on the loan even better. This strategy calls for the homeowner to borrow back the principal portion of every mortgage payment, and invest it in an income-producing portfolio. Under the Canadian tax code, interest paid on monies borrowed to earn an income is tax-deductible.

As time progresses, your total debt remains the same, as the principal payment is borrowed back each time a payment is made. But a larger portion of it becomes tax-deductible debt. In other words, it's considered good debt. And, less remains of non-deductible or bad debt.

Traditional vs. Tax-Deductible Mortgage Strategy

To better demonstrate the strategy, we can compare a traditional mortgage payoff to the tax-deductible mortgage strategy. First,  we look at an example of a Canadian couple who pays off a mortgage in the traditional way and contrast that to the tax-deductible method.

Traditional Mortgage

Suppose Couple A buys a $200,000 home with a $100,000 mortgage amortized over 10 years at 6%, with a monthly payment of $1,106. After the mortgage is paid off, they invest the $1,106 that they were paying for the next five years, earning 8% annually. After 15 years, they own their own home and have a portfolio worth $81,156.

Tax-Deductible Mortgage Strategy

Now let's say that Couple B buys an identically-priced home with the same mortgage terms. Every month, they borrow back the principal and invest it. They also use the annual tax return that they receive from the tax-deductible portion of their interest to pay off the mortgage principal.

They then borrow that principal amount back and invest it. After 9.42 years, the mortgage will be 100% good debt and will start to produce an annual tax refund of $2,340 assuming a marginal tax rate (MTR) of 39%. After 15 years, they own their own home and have a portfolio worth $138,941. That's a 71% increase.

Tax-Deductible Mortgage Benefits

The goals of this strategy are to increase cash flow and assets while decreasing liabilities. This creates a higher net worth for the individual implementing the strategy. It also aims to help you become mortgage-free faster and start building an investment portfolio faster than you could have otherwise. Let's look at these a bit closer:

• Become mortgage-free faster. The point at which you are technically mortgage-free is when your investment portfolio reaches the value of your outstanding debt. This should be faster than with a traditional mortgage because the investment portfolio should be growing as you make mortgage payments. The mortgage payments made using the proceeds of the tax deductions can pay down the mortgage even faster.
• Build an investment portfolio while paying our house down. This is a great way to start saving. It also helps free up cash that you might otherwise not have been able to invest before paying off your mortgage.
  

Know the Risks of the Tax-Deductible Mortgage Strategy

One important point to note is that this strategy is not for everyone. In fact, it can be risky if you don't know how to navigate it. Missing or skipping a mortgage payment could derail any progress. Borrowing against your home can be psychologically difficult. Worse, if the investments don't yield the expected returns, this strategy could yield negative results.

By re-borrowing the equity in your home, you are removing your cushion of safety if the real estate or investment markets, or both, take a turn for the worse. By creating an income-producing portfolio in an unregistered account, you may also face additional tax consequences.

Be sure you consult with a professional financial advisor to determine whether this strategy is for you. If it is, have the professional help you tailor it to you and to your family's personal financial situation.

Example of a Tax-Deductible Canadian Mortgage

To explain this better, refer to the example below, where you can see that the mortgage payment of $1,106 per month consists of $612 in principal and $494 in interest.

As you can see, each payment reduces the amount owed on the loan by $612. After every payment, the $612 is borrowed back and invested. This keeps the total debt level at $100,000, but the portion of the loan that is tax-deductible grows with each payment. You can see in the above figure that after one month of implementing this strategy, $99,388 is still non-deductible debt, but the interest on $612 is now tax-deductible.

This strategy can be taken a step further: The tax-deductible portion of the interest paid creates an annual tax refund, which could then be used to pay down the mortgage even more. This mortgage payment would be 100% principal (because it is an additional payment) and could be borrowed back in its entirety and invested in the same income-producing portfolio.

The steps in the strategy are repeated monthly and yearly until your mortgage is completely tax-deductible. As you can see from the previous figure and the next figure, the mortgage remains constant at $100,000, but the tax-deductible portion increases each month. The investment portfolio, on the side, is growing also, by the monthly contribution and the income and capital gains that it is producing.

As seen above, a fully tax-deductible mortgage would occur once the last bit of principal is borrowed back and invested. The debt owed is still $100,000; however, 100% of this is tax-deductible now. At this point, the tax refunds that are received could be invested as well, to help increase the rate at which the investment portfolio grows.

The Bottom Line

If you're a homeowner in Canada, you may be able to use the equity in your principal residence and take out a loan to buy an investment property. Interest on a mortgage for income-driven properties is fully tax-deductible, which allows you to lower your tax liability and save some money. But just like any other venture, it's important to outweigh the benefits and the risks. If this is something you'd like to investigate, consider talking to a financial professional before you make any decisions.