Thanks for all the comments about Capital vs Expense…though I didn’t mean to go down that garden path! I’m going to redirect to what the Smith Manoeuvre book terms “capitalization of interest”.
First of all, being an accountant, I have capitalized interest in a major oil and gas company on a multi billion dollar project which issued debt (bonds) to help pay for the construction. So in simplistic terms, what Tod touched on is how I have calculated capitalized interest.
What intrigued me about what the book terms “capitalized interest”, is the average Joe Smith can easily create another tax deduction by paying LOC-A’s interest with LOC-B (see original conversation). LOC-A’s interest is a tax deduction because it was used to purchase investments and LOC-B’s interest would also be a tax deduction. This was a “hmmm” moment for me as I wouldn’t have thought to add this extra step to my matrix mortgage (Smith Manoeuvre) that I’ve just set up. I would have paid my LOC-A with cash.
Below are excerpts from “Is your mortgage Tax deductible? - the Smith Manoeuvre” by Fraser Smith. If you have the book, the whole conversation is on page 72 to page 74. It’s a few short paragraphs….for clarification, F.Smith terms bad debt your mortgage that isn’t tax deductible and good debt the LOC tied to the mortgage that is used for investment purposes. All the italicized paragraphs are direct quotes from the above mentioned book.
Has ANYBODY done this with their LOC’s???!!!
eight:100%">Hope this provides some food for thought!
There is another rarely understood strategy available to Joe that provides him and advantage without costs. It is called capitalization of interest.
Suppose you have a loan for $10,000 and the interest for the current month of $100 is due. You could open your wallet and turn over the $100 to the lender to pay the rent on the loan. IF you have cash flow problems, you might be able to convince the lender to add the interest expense to the principal owed so that now you owe the lender $10,100.
This procedure is called capitalizing the interest – the interest has been converted to capital. Next month you will have to pay interest on $10,100.
Banks don’t usually like to capitalize consumer debt – they would prefer at the least to be receiving monthly interest, in which case the principal would stay constant, but interest would not accumulate. Many loans, such as mortgages and term loans are set up as amortizing loans where a monthly payment covers the interest expense for the month, plus an amount that reduces the principal of the loan.
When the banker capitalizes interest, he is simply lending you more money.
o-->The CRA specifically advises in Section 20(1)Â that if interest on a loan is deductible, then so is the interest on the interest. In other words, compound interest on deductible loans is deductible. The rule to follow is this – as long as you still have any non-deductible debt such as your mortgage, capitalize the interest on deductible debt so that your tax-paid cash flow can be used to overpay your bad-debt mortgage faster. Divert every tax paid dollar you can find against your first mortgage – don’t use your cash to pay for investments or to pay deductible interest – these items should be paid with borrowed money.
I believe there was a note at the end of the book saying it was Section 20(1)(d) of the tax act that he was applying.
Take care,
Susan Penner, B.Comm, CMA
