How Rental Cash Damming Can Save You Thousands

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This article originally appear in the May 2014 edition of Canadian Real Estate Magazine

The cost of mortgage interest and taxes are really eating into my monthly cash flows. I want to take advantage of investment opportunities in my locality but these costs are proving too much of an obstacle. What can I do to help reduce these costs?” Our new resident mortgage and finance expert, Jason Henneberry, answers this question.

Q: What are the primary mistakes that investors make when it comes to tax and interest costs?

A: As investors, we have been taught to keep our personal and rental expenses separate to maintain a clear audit trail for tax purposes. As a result, many Canadian investors are missing out on a powerful opportunity to save taxes, reduce interest costs and improve the return on investment from their portfolio. This is accomplished through a financial technique known as rental cash damming, where investors use the cash flows from their rental portfolio to convert their primary residence mortgage into a tax deductible investment loan.

Q: How Does Rental Cash Damming Work?

A: Real estate investors understand that when you borrow money to purchase a rental property, the mortgage interest is tax deductible. The same goes for any expenses related to carrying the property, such as maintenance costs, property taxes, condo fees, etc. By extension, the interest cost on any money that is borrowed to pay for these expenses is also tax deductible. Smart real estate investors leverage this fact to optimize their cash flows for greater tax efficiency. This is accomplished by using the rental income from their portfolio to pay down their primary residence mortgage and then borrow the money to fund their monthly rental expenses. This process is known as “debt-conversion” and will generate increased tax refunds over time. Investors are advised to use the tax refunds to pay off their mortgage faster, thereby reducing long term interest costs.

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5 investor mistakes that kill profits

1. Waiting for the ‘perfect time’ to invest in real estate.

There are profits to be made in all phases of the economic cycle, as long as your strategy is right. While you’re waiting for the ‘perfect time,’ other investors are scooping up fantastic deals and starting to generate profits.

2. Not developing a strategy in advance

It’s essential to set some realistic goals, define a plan for achieving them and establish clear benchmarks so you’ll know how much progress you’re making. Be clear on the number of properties you can handle, financing strategy, investment strategy, due diligence, etc. Most important, know your exit strategy before you buy.

3. Waiting until you have the cash

While offering full cash can result in big price discounts, it’s unrealistic for most investors, especially first timers. But there’s no need to spend years saving and missing out on opportunities. The key to most successful real estate investments is using OPM (other people’s money).

4. Not doing the research and getting to know your market

The only good decision is an informed decision. Don’t even think about buying an investment property unless you fully understand the local market, zoning laws, pricing trends, wholesale opportunities, rental demand, local transit and amenities, etc.

5. Not taking advantage of a tax deductible mortgage

Instead of simply letting your equity build up, you extract it and use it to purchase revenue properties. Any time you borrow money to make an investment; the interest is tax deductible, which in effect creates a tax deductible mortgage on your home. If you use your increased yearly tax refund to make further investments, the benefits multiply even more.
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Q: How Does Rental Cash Damming Work?

A: Real estate investors understand that when you borrow money to purchase a rental property, the mortgage interest is tax deductible. The same goes for any expenses related to carrying the property, such as maintenance costs, property taxes, condo fees, etc. By extension, the interest cost on any money that is borrowed to pay for these expenses is also tax deductible. Smart real estate investors leverage this fact to optimize their cash flows for greater tax efficiency. This is accomplished by using the rental income from their portfolio to pay down their primary residence mortgage and then borrow the money to fund their monthly rental expenses. This process is known as “debt-conversion” and will generate increased tax refunds over time. Investors are advised to use the tax refunds to pay off their mortgage faster, thereby reducing long term interest costs.

Q: What is the typical investor profile for someone that wants to take advantage of this rental cash damming
strategy?

A: In order for an investor to be eligible for the rental cash damming strategy, they must own at least one rental property (in their personal name) and carry at least $50,000 of “non-deductible” mortgage debt on their principal residence. The more properties an investor owns, and the greater the outstanding balance on their principal residence mortgage, the more impressive the financial benefits.

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Case Study

Ken and Nancy have a $350,000 non-deductible mortgage that was used to purchase their primary residence. They will pay off their mortgage in 25 years, assuming an average long-term interest rate of 4.50 per cent and monthly payments of $1,937. They also own three rental properties with annual expenses of $66,750 (including mortgage principal and interest, property taxes, condo fees, insurance and maintenance).

Ken and Nancy decide to implement the rental cash damming strategy to convert their principal residence mortgage to a tax deductible investment loan. They use the rental income from their portfolio to pay down their mortgage and they lend themselves the funds to cover the expenses on their rental portfolio. By doing this, they will increase their tax deductible debt by $66,750 every year and the remaining balance of their primary residence mortgage will be 100 per cent tax deductible within 3.5 years. Over the life of their mortgage, they will generate $58,798 in free tax refunds, and they will use the tax refunds to pay off their mortgage faster and reduce their interest costs by an additional $43,871. They will save a total of $102,669 simply by reorganizing the cash flows that are already in place. There is no additional financial contribution required to make the strategy work.

Another way to look at this is to say they have a pre-tax benefit of$168,310, which is the amount of income they would have had to earn (at a 39 per cent marginal tax bracket) in order to realize the same amount of savings.

Do you think this strategy could work for you and your portfolio? As a reader of Canadian Real Estate Wealth, you can download a comprehensive insight into this case-study and further information on this strategy @ www.mortgagepal.wpengine.com/casestudy
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Q: How much, on average, can an investor save by being more astute with structuring their portfolio to save on tax and interest costs?

A: There are a number of variables to consider and the savings potential can be significant for the right investor. Many of our clients are saving tens of thousands of dollars in unnecessary interest and taxes by applying
this technique. A typical investor with three to four rental properties and $350,000 in “non-deductible” mortgage debt stands to generate a pre-tax savings of more than $150,000 over the life of their mortgage. What usually surprises people is that they are able to achieve these benefits without any additional financial input beyond their existing portfolio cash flows.

Q: What steps should an Investor take to properly execute the strategy?

A: The first step is to speak with a professional mortgage planner that understands how rental cash damming works. They should be able to provide you with financial benefits projections and help determine eligibility for the strategy. Once you’ve decided the strategy is for you, the next step is to setup your primary residence mortgage so that you can re-advance principal after it has been paid down. This is typically referred to as a HELOC structure – investors should be cautioned that not all HELOC products are created equal and some can cause administrative headaches when implementing this strategy. The final step is to calculate the precise amounts that will be cash dammed and “approve” the monthly cash flow cycle. At this point, you are ready to begin executing transactions to convert your principal residence mortgage into a tax deductible investment loan. Investors are reminded that they should seek tax advice from a chartered accountant prior to executing this strategy.

Want to see how Rental Cash Damming could benefit you?

Reach out to us for a conversation – we’re happy to chat about your investment strategies.