Tax Strategies
For almost any household, income taxes are by far the single biggest expense facing any family. By using the tax strategies below, you can dramatically reduce your tax bill. Tax refunds over the years, wisely invested, can result in a huge increase in your retirement capital, allowing you to retire earlier, or to retire with a much better lifestyle. Avoiding the tax man is not cheating – what we are talking about here are legitimate tax deductions that actually help the country. Tax planning is an essential part of financial planning and continuous tax relief is a fabulous way to build wealth. However, there are no free rides in life, and most tax strategies require taking more risk – risk that is rewarded (and should be) by tax deductions.


Borrowing money to invest is called investment leverage. The interest on this kind of loan is generally tax deductible if the investment purchased earns or potentially earns income. A good example of using leverage is something that most Canadians do. They borrow to buy their homes and then slowly pay this loan (mortgage) over time. Because the home is a personal asset, the loan interest is not tax deductible. Nevertheless, as a leverage strategy, this works out pretty well. Real estate has grown at about 5% per year, so if you borrow 75% to buy your home, in 5 years it's grown in value by 25% (ignoring compounding). Because of leverage, your equity in the home has grown by 50% plus whatever you have paid off on the mortgage. This is a great way to build wealth.

But let's look at how we can use investment leverage to also build our wealth. Leverage involves additional risk so be sure to check out my section on risks. Investment leverage strategies are not for everyone.

Debt swaps
Debt swaps entail replacing non-deductible debt with deductible debt. Let's look at an example to see how it works:

Jason has non-registered investments worth $50,000. He also has a house worth $400,000 and a $200,000 mortgage. He has an unused home equity line of credit (HELOC) secured by the house with available credit of $100,000. A debt swap consists of selling the non-registered investments, using the proceeds to pay down the non-deductible mortgage, and then borrowing the same amount using the line of credit and making new (or even the same) investments in a non-registered account. The line of credit interest is tax deductible because the loan proceeds are used to make an investment. The order of events is very important here – the loan proceeds must be used to make the investment. This strategy has been blessed by court cases including the famous "Singleton Shuffle" and even more recently the Lipson case (the taxpayer lost but the judgement pretty much blessed a straight forward debt swap). Please note however, that each person's circumstances are different and the above noted cases and situations may not apply to you. And if CRA disputes your tax deductions, you may incur legal costs and may have to present your case to the courts, and of course, you might lose. Poor execution of any tax reduction strategy always bears the risk of disallowal.

I have seen some blogs where the blogger stated that the loan interest would not be deductible if used to buy an investment where the return would be in the form of capital gains (because capital gains are not considered income). This would be true if the only potential return would be capital gains, but that is rarely the case. Let’s say for example that someone used borrowed money to buy a certain large well known software company's stock 10 years ago. At the time, the company was not paying a dividend, so at that point the only kind of return you could get was in the form of capital gains. But because there was still the potential to earn dividend income at some point in the future, the courts have ruled that the loan interest is still deductible. And as it happens, the company eventually started paying dividends, which just proves the point. The CRA recently issued a tax bulletin confirming this interpretation (IT-Bulletin 533).

Although a debt swap does not increase your overall risk (and one could argue that it decreases it slightly because your interest becomes tax deductible therefore your cash flow is improved), a more conservative option would be to simply liquidate the investment and pay down the debt.

Leverage as an alternative to savings
Imagine you have the ability to save $200 per month. After 12 months, if you earn a return of 6%, you will accumulate $2,467. Now, if instead, you borrow $60,000 at 4%, you will pay the same amount in interest as you were previously saving ($200 per month) but at the end of the year, assuming the same return, your investment return will be $60,000 times 6% = $3,600. And on top of this return, your interest is tax deductible, so your actual out of pocket cost is less than $200 per month, depending on what your marginal tax rate is (or MTR, which is the tax rate on the last dollar earned or first dollar deducted – see for an online tax calculator). If you want to play with various scenarios, check out Talbot Stevens' website at where you can download software that illustrates various leverage scenarios.

The risks of pursuing this strategy are the same as in the Smith Manoeuvre below except you would not have distribution risk.

The Smith Manoeuvre
Named after Fraser Smith, this strategy involves a series of "mini-debt swaps". Before this strategy was developed, conventional wisdom held that you paid off your mortgage before starting to invest outside of RRSPs. Fraser got the notion that, as you pay off your mortgage each month, why not immediately borrow back the same amount as the principal repayment and invest this every month (the mini-debt swap). Gradually, as the non-deductible mortgage is paid down, it is replaced by a deductible investment loan and a growing investment nest egg. Some Smith Manoeuvre enthusiasts claim that you are converting your mortgage to being tax deductible, but technically this is not true – rather, you are paying down your mortgage faster and replacing it with tax deductible debt i.e. reducing debt, then increasing debt again.

One of the great features of this strategy is that it uses the principle of dollar cost averaging – that is, making regular monthly investments when the markets are both rising and falling.

    (a) Detailed description
    For the Smith Manoeuvre to work properly you need a readvanceable mortgage, which means you have a mortgage connected to a line of credit, both secured by your home. As you pay down the mortgage, the credit limit on your line of credit goes up by the same amount. By advancing this available credit either directly to an investment, or to a bank account and then to an investment each month, we are can build-up our non-registered investment portfolio using dollar cost averaging. Fraser calls this version of the Smith Manoeuvre the "Plain Jane".

    The Plain Jane Smith Manoeuvre is kind of slow but there are a couple of ways to accelerate it. First, you can increase the amount you are paying down on the mortgage. For example, assume your regular mortgage payment has a $500 principal repayment at a given time. If you can afford to save an additional $200 per month, then you increase your mortgage payment by $200 and then increase your monthly investment by the same amount, which accelerates the process. Another way to accelerate is to take your tax refund when you get it and pay down your mortgage by the same amount and then borrow it back and invest it. Similarly, any bonuses, small lottery wins etc. can also be used to pay down the mortgage and then they can be reborrowed and invested.

    By far the most effective (but riskier) way to accelerate the S.M. is to use additional investment leverage. Let's look at a specific example to show how it works. You have a home worth $400,000 and a mortgage of $200,000 and equity of $200,000. The mortgage payment is $1,500, comprising interest of $1,000 and principal repayment of $500. Here's how it works:

    Method 1: You obtain a home equity line of credit (HELOC) for $100,000 secured on the house and connected to the mortgage (readvanceable). This may require refinancing. Certain financial institutions will make investment loans on a 2 for 1 basis, that is, if you write a cheque for $100,000 they will lend you $200,000 to make an investment. This would be used to purchase investments and the lending institution holds these as security on the loan. Since you have given them $100,000, they initially have $300,000 worth of investments as security and you owe them $200,000. Since you borrowed the $100,000 too, at the start of this process you have $300,000 of investments offset by $300,000 of loans. How you do down the road will depend on your investment return. By paying a little more in interest you can make the loan no margin, which means it doesn't matter how the investment does in the short run, you will not be asked to come up with more security. All of the investment loan and the line of credit loan interest will be tax deductible if the strategy is executed properly.

    Here's the neat part of the strategy: the investment purchased with the borrowed funds can be a T series fund, which means a set percentage of the investment is distributed to unit holders monthly. For example, a T8 series fund pays an 8% cash distribution. This distribution usually incurs little tax because most of it is in the form of a non-taxable return of capital. The remainder of the return is in the form of capital gains, dividends and interest. For a 2 for 1 loan, the investment loan company permits the investor to have this distribution deposited to their bank account. We can use this cash payment to increase the amount by which we pay down the mortgage. Using the example above, if we borrow to buy $300,000 of a fund paying an 8% distribution, then we will receive 8% of $300,000 every month or $2,000. We can use this additional cash flow to pay down our mortgage, which when added to our $500 principal repayment, means we end up with an additional $2,500 of credit room in our HELOC. However, we have to pay the interest on the investment loans, so if our interest rate is 4%, we will need $300,000 times 4% divided by 12 months = $1,000 per month, leaving us with $1,000 to invest every month. As you can see the strategy is cash flow neutral i.e. there are no additional funds coming out of your bank account. (but be sure to see risk section below)

    Method 2: Rather than use a HELOC, you can borrow 100% from the investment loan company. The interest rate is probably going to be higher and there may be other restrictions and limitations and the underwriting is going to be stricter (because the loan company has less security).

    As in Method 1, we will receive a monthly distribution which we can use to first pay the interest on the investment loans. However, in this case, in order to receive the distribution in cash we must pay both principal and interest on the investment loan (but not the line of credit) so our net cash flow will be a little less than in Method 1, so Method 1 is preferred if you have sufficient equity in your house or can raise the cash down payment from some other means (by putting up existing non-registered investments as security for example).

    In either case, in practice this strategy is pretty complex to implement, so generally you will want advice from an expert (like me for example).

    (b) The concept of breakeven
    The Smith Manoeuvre is a leverage strategy which can increase returns but can also increase losses. If the interest was not tax deductible, the strategy is a winner if long term returns are higher than the interest cost. So if your average rate of interest is 4%, then you are ahead if your investment return exceeds 4% and you are behind (negative) if the returns are less than 4%. The 4% represents your breakeven point. But interestingly, if your interest is tax deductible, and your return consists of return of capital, capital gains and dividends, then your breakeven will be less than your borrowing costs. A rough rule of thumb is that if you are in the top tax bracket, your breakeven point will be about 2% less than your borrowing cost.

    (c) Risks
    In simple terms, the strategy described above can generate substantial returns but not without risk (all investment strategies involve some degree of risk and leverage strategies have higher risk). A more conservative option would be to simply pay down your mortgage – it depends on your tolerance for risk. Aside from the specific risks identified below, keep in mind that if you use your home as security you could possibly lose your home if things go badly. Here is a list of the risks that I have identified (there may be others that I haven't thought of):

    • Performance risk: The investments can have negative returns over the short term and even the long term. Beta risk is the risk of the general markets, and alpha risk is risk of the particular investment you are in. However, the longer you hold an investment, the likelihood of major underperformance or deviation from historical average returns diminishes, which is why most advisors emphasize that leverage investing is a long term proposition.
    • Distribution risk: The distributions are not guaranteed and they may be reduced (or increased) depending on market conditions. If the distributions are cut, then the monthly investment would be reduced by the same amount, but if the distributions are cut a lot or eliminated, then the possibility exists of negative cash flow. Distributions can and have been cut when the return of capital distribution (known as a "ROC") results in erosion of the original capital. This would occur when the performance of the investment is well below the percentage distribution. For example, this happened in the period 2007-2009 when the markets were severely depressed for a long period and a number of invesment companies reduced or eliminated their distributions.
    • Emotional risk: An investor may be very comfortable with risk when the markets are up and very uncomfortable when they are down. If this discomfort causes them to abandon their strategy, then paper losses can be turned into real losses. Putting it another way, an investor may think they have a high risk tolerance, but adverse market conditions may prove otherwise.
    • Tax risk: The government may change the rules regarding tax deductibility or there may be adverse court rulings. Changing the rules of course is hard to predict but I think it unlikely because there would be huge risks to the government from the economic consequences of changing the interest deductibility rules. One can make a very good case that the economy in general is improved and functions better because of investment leverage. Since we have had several definitive court cases recently, I do not consider it very likely that we will see adverse court cases either. Another possibility is that in pursuing a tax reduction strategy you mess up the execution in a manner that CRA disallows the deduction. Or they disallow it, but they are wrong, and you have to fight them, possibly go to court, with all the attendant costs and time, or simply give up (see How to Switch Mortgage From Non‐Deductible Residence to Deductible Rental Property for an interesting extract from a recent court case).
    • Interest rate risk: Interest rates vary over time, and it is possible that they could rise a lot, which would negatively affect a leverage strategy. In my opinion, the chances of a prolonged period of high interest rates are unlikely. Furthermore, when interest rates trend higher on a long term basis, other rates of return generally trend higher (real estate returns, stock market returns, dividend returns etc).

      Investment leverage is not for everyone, and to assess whether it is right for you, you need to consult with an experienced investment advisor and particularly one who is familiar with investment leverage strategies.

    (d) Best mortgages for the Smith Manoeuvre
    For a discussion paper on what the perfect Smith Manoeuvre would look like, and which companies have products that come close to the ideal, click on The Perfect Smith Manoeuvre Mortgage.

4 in 1 concept

Let's say you’ve been saving $400 per month and putting this into an RRSP. There is another way to save and still have the same tax deduction. We take $200 of the $400 and instead of putting this into an RRSP, we use it to pay interest on a $60,000 loan. We have the same tax deduction at the end of the year - $2,400 for an RRSP contribution and $2,400 for tax deductible interest.

Why 4 in 1? Because we are:
  1. Using dollar cost averaging with the RRSP
  2. Building up RRSP assets
  3. Building up non-registered assets
  4. Getting the same tax deduction
Risks are the same as in the Smith Manoeuvre above except we don't have the distribution risk.

Other ways to make mortgage interest deductible

Often I find clients who have a large mortgage on their personal property and little or no mortgage on their rental property. This is generally a result of bad planning because the personal mortgage interest is not tax deductible while the rental property mortgage interest is tax deductible. The question is: is there any way to correct this? A recent court case suggests that there may be a way to fix this. Interestingly, the taxpayer in this case lost, but in the judge’s commentary, he suggested a way that might work. To find out more, click on How to Switch Mortgage from Non-Deductible Residence to Deductible Rental Property.

RRSPs I think pretty much everybody in Canada knows how RRSPs work so I’ll confine myself to describing what I like and dislike about them. I like that they encourage people to save long term for their retirement. I like that they can grow tax deferred for a long time. The advantage to tax deferral is that you can have growth on the growth (as Einstein said "The most powerful force in the universe is compound interest"). So even if your marginal tax rate is the same as when you were accumulating the RRSP assets, you can end up with more capital than if you paid the tax on the growth each year. And for many people, their marginal tax rate when they retire is actually lower than when they were accumulating.

Here's what I don’t like about them. First of all, tax changes over the last couple of years means that for non-registered investments (RRSPs, RRIFs, and RESPs are all registered investments), capital gains are taxed at 50% and dividend income is taxed at roughly 50% depending on what province you live in. These are absolute tax savings, not just deferral. And with capital gains we also have deferral – we don't pay tax until we actually sell the investment. Together these measures make RRSPs less attractive in comparison, because the absolute tax savings on capital gains and dividend income are lost when the investment is held within an RRSP.

Let me tell you a little story. I have clients who have almost all their assets in RRIFs (RRIFs are simply RRSPs that have been converted after retirement to an income producing vehicle). She has a good pension. With their normal RRIF payments and pension income, they both have taxable income at around $65,000 each. For anything they earn over $65,000 their OAS starts to get clawed back. At about $95,000 it is totally clawed back. This makes their effective marginal tax rate in this range about 52%. Now what happens when they want to go on their Florida vacation (about $15,000), European cruise ($10,000) or pay for their boat at the marina ($12,000)? As soon as they withdraw from their registered assets, they have to pay 52 cents on the dollar. Not good!

So for anybody with a good pension (teachers, government employees, employees of any large corporation etc.) accumulating RRSPs doesn't make sense to me. If the couple above had accumulated non-registered assets, they would have had a fair bit of tax deferral and they would have had absolute tax savings on capital gains and dividends. They would only pay a little capital gains on their capital when they withdraw it.

Planning point: keep you conservative interest bearing investments in an RRSP and your equity investments that generate capital gains and dividends in your non-registered plans (including TFSAs).

There are lots of people out there who have pension incomes or will have them in the future at around $65,000 so they potentially face a very high tax rate (higher than Hal Jackman, or Paul Desmarais). Keep in mind that when the last spouse dies, the entire RRSP or RRIF is added to their income for the year, so if it is a sizable amount, a large chunk of it will be taxed at the top marginal rate i.e. up to 52%.

How about spousal RRSPs? I don’t much see the point of this added complexity now that we can split pension income (more on that elsewhere) so I wouldn't even bother with these now. Bottom line here is that I think you should reach retirement with a combination of registered or pension funds and non-registered capital.

RRIFs RRSPs are an accumulation of contributions that create a tax deduction in the year of the contribution or 60 days in the year following. RRIFs are converted from RRSP plans and in work in reverse fashion, that is, they allow you, the planholder, to continue to defer tax but you must withdraw a prescribed amount each year and pay tax on this withdrawal. You must convert your RRSP to a RRIF by the end of the year you turn 71. RRIF income received after you turn 65 is eligible for both the $2,000 pension income credit and income splitting (more on that elsewhere). One small planning point is that if you don’t need the full RRIF payment, and you have a younger spouse, you can have the payments based on your spouse's age.

TFSAs These are a great way to save non-registered capital for your retirement. Although you don’t get a deduction at the time of contribution, you don’t have to pay tax on your later withdrawals, so it avoids the problems I described under the RRSP section. I think these are particularly useful for those with good pensions, limited RRSP contribution room (usually the same folks), or uncertain income (because they can be accessed with no penalty in case of emergencies). If you have an investment that you think will go to the moon, put it into a TFSA. Or alternatively, if you have a special fund for emergencies, or a savings account, move the funds over to a TFSA. In other words, a TFSA is good for both conservative and aggressive investments.

Income Splitting
In Canada, individuals file tax returns, not couples. Because of our progressive tax system, tax rates go up as your income goes up. So if one member of a couple makes a lot, and the other very little, they pay far more tax than if the income were evenly split between the two individuals. A simple example will highlight the difference.
  • John and Mary Oldfashion. John has a taxable income of $120,000 per year and Mary has no taxable income. Their total family tax bill is $36,719.

  • Bill and Jane Evensteven. Both Bill and Jane each have a taxable income of $60,000 so there total family income is the same as John and Mary. But their total family tax bill is $25,224 which is $11,495 less than John and Mary’s total tax bill. That's a huge difference.
There are many ways to split family income, but CRA also has many rules that limit income splitting. There are basically three kinds of income splitting: 1) income splitting before retirement 2) income splitting after retirement and 3) income splitting after death.

Income splitting before retirement

Here are some ways to split income before retirement:
  • Hiring Spouses and Children – If the higher income spouse is running a business they can hire their spouse or children and pay them a wage. The spouse or children actually have to do work, and the value you ascribe to it must be reasonable and supportable.

  • Prescribed Rate Loan - The Income Tax Act (ITA) has attribution rules to prevent a higher income spouse from transferring assets to a lower income spouse but the higher income spouse can lend money to the lower income spouse at a prescribed rate, currently at an all time low of 1%. Once established, the loan rate does not need to be reset.

  • Spousal RRSPs – As described under the RRSP section, this strategy is less attractive because of the pension income splitting option. Having spousal RRSPs adds unnecessary complexity to a portfolio, so I generally wouldn’t bother with them anymore.

  • Savings by lower income spouse - The higher income spouse can pay all the household expenses and the lower income spouse can save all their income to build-up non-registered savings. This can help even out the capital positions of both spouses and thus even out their post-retirement income.

Income splitting after retirement

Before age 65, only company pension and superannuation annuities qualify for income splitting or annuities arising from the death of your spouse. If you don't have a company pension, it’s kind of hard to split income. After attaining age 65, RRIF income qualifies, so if you haven't converted your RRSP to a RRIF or annuity, that’s the time to do it. Income splitting is only going to work if you and your spouse are in different income brackets. When I'm doing a couple’s tax return and they have qualified pension income, I run a pension splitting optimizer to determine how much to move over. It’s not always obvious what the right amount is, so this routine is very important and sometimes I can save my clients thousands of dollars in tax.

Income splitting after death

Testamentary Trust - An excellent way to split income after death is to create a testamentary trust in your will. A testamentary trust is taxed separately and like an individual taxpayer, there are graduated rates (but no personal exemption). Let's look at an example:

Laura is 80 years old and has 3 grown children, all of whom have high taxable incomes (over $120K). Laura’s total capital is $3 million. If she simply leaves 1/3 to each child, each of them will be paying tax at the top rate on the additional income from their inherited capital. If we assume that this capital would generate a taxable income of 4% or $40,000 each, they would pay an additional $18,400 each in tax per year. But if Laura's will specified setting up a trust for each child (3 trusts), then the trusts would pay tax at the graduated rate. Each trust would pay tax of $6,400 so the family would save $36,000 ($18,400-$6,400 times 3) every year. If one of the beneficiaries needs all or a portion of the capital, that’s not a problem because we make sure that the trusts allow for capital encroachment (capital depletion).

Keep in mind that the individual trusts will have to file a tax return every year, which will probably cost $250 to $400 per year, but the tax savings make this expense well worth it.

Capital Gains/Losses
Capital gains are a wonderful way to make money because they are taxed at 50% less than interest and employment income but the best part is that they are only taxed when you sell the investment, so potentially you can defer them almost forever (when you die, you can pass to your spouse tax free, but if there is no spouse, the tax is then payable). Combining absolute tax savings with tax deferral is a beautiful concept and it makes sense too. You should be rewarded for taking a risk – capital gains are sometimes hard to get. The only bad part of capital gains is when they aren't gains but are losses. You can only offset these against capital gains. Capital losses can be applied back 3 years to offset previously declared capital gains or can be carried forward forever to be used against future capital gains.

To show the power of tax deferred growth, let's look at an example:
    Bob has a stock his grandfather left him (his cost base would be equal to the value on the day his grandfather died) and it was worth $30,000 on the day he inherited it. It pays him no dividends but grows steadily in value year after year at 5% per year. Bob's wife Mary has a GIC that her mother left her on the same day that Bob’s grandfather left him his inheritance (an amazing coincidence) that is also equal to $30,000 and it also grows on average 5% a year. Mary pays the tax on the GIC, but does not take out the interest and she reinvest this at 5% every year too. Both are in a 40% tax bracket. So now let's see how they’ve done 20 years later.

    Bob's $30,000 has grown to $79,598.93 and Mary’s has grown to $54,183.34. To be fair, Mary has paid the tax each year and Bob has not, so let's assume that Bob now sells the stock. If he didn’t have the capital gains 50% exclusion, Bob would pay $19,839.57 in tax, leaving him $59,759.36 which is $5,576.02 more than Mary has, even though they started with the same money at the same time and had the same rate of return, all because of the power of compounding (see Power of Compounding for another example of the power of compound interest). And if we then take into account the 50% inclusion rate, that means Bob's actual tax would only be 50% of $19,839.57, leaving him with $69,679.14 versus Mary’s $54,183.34.

Dividends are distributions of after-tax profit to registered owners of common or preferred shares. These are usually paid quarterly. There are many kinds of dividends but I will confine this discussion to the most common, which are eligible dividends. Dividends from large corporations like banks, manufacturers, oil and gas companies etc. are usually going to be eligible. Eligible dividends are subject to gross-up (making them bigger) offset by a dividend tax credit. We don't need to get into the mechanics of this. The important thing is that eligible dividends are taxed much less than interest income. The exact amount of tax depends on which province you live in. As a percentage of the full tax rate on interest income, they vary from 37.3% in Alberta to 61.6% in Quebec (see for tax calculator for Canada). The rate for Ontario is 49.7%, so dividend income is taxed slightly less than capital gains income in Ontario. However, there is no tax deferral – the tax on dividend income is due in the year the dividends are received.

Automobiles – Lease vs. Buy

For a discussion of the perennial question "Should I lease my automobile or buy it" click on
Automobiles – Lease vs. Buy.

If you have any questions or comments, feel free to email me at