Caution when considering a HELOC to supplement living expenses

Getting a full picture of the financial trade-off

Through no fault of their own, a family may find themselves in the position where their income is not keeping up with their cost of living. Whether operating under one or two incomes, one option they may be considering is a home equity line of credit (HELOC) to supplement their household needs.

A HELOC can indeed provide breathing room to a family, but preferably it is coupled with a plan on how they will emerge from that pause when their finances are back on track.

When an emergency fund isn’t enough

On a short-term basis, borrowed funds may be necessary to bridge the gap if there are expenses in excess of income. For example, someone may become unexpectedly unemployed and doesn’t have an emergency fund, or needs to stretch out that emergency fund to accommodate a longer transition back to work.

Still, it should be appreciated that like any borrowing, this is using future income to support current living costs, which can become unsustainable if one is not careful. Once beyond the employment gap and stabilized, the elimination of the line of credit ought to be a top priority.

Tax cost of non-deductible interest

Interest may be tax-deductible when money is borrowed for business or investment purposes. But if loan proceeds are being used to “live on”, those are non-deductible personal expenses. The person’s other income must be earned and taxed before cash is then available to pay the interest charges.

With each additional draw on the line of credit, interest will become an increasing drag on that other income. The build-up may be slow, but it will progressively reduce the spendable amount of those other income sources, again bringing into question the sustainability of the practice.

Accordingly, there must be a plan as to how and when the principal is to be paid down/off, else it becomes so large that only the sale of the home will be sufficient to pay off the debt. This could be especially damaging if market conditions are not in a seller’s favour when the homeowner may be compelled to take action.

Appeal and concession of capitalized interest

With some loans – which is fundamentally the nature of a line of credit – the lender may not require regular principal payments. Or, the lender may permit some or all of the interest to be capitalized to the principal.

While this may be appealing for immediate cash flow, it results in faster growing debt. The borrower remains responsible for the interest on the principal, and must now pay interest on the interest on a continuing basis.

That’s the compounding effect that is often highlighted when investments grow through reinvested income, but here it’s working in the opposite direction.

Compound interest as an expense will erode home equity at an accelerated pace if not understood, monitored and serviced. In addition, unlike investments that have an open-ended opportunity to grow in a positive direction, a lender will have a maximum limit for a line of credit, generally tied to the practical boundary of (a percentage of) the market value of the property that is the collateral.

Aging-in-place in retirement

Longer term, particularly in retirement, a homeowner/borrower must be extra cautious about the effect this may have on their future housing options. Downsizing to a smaller property may be part of one’s financial plan, but just how far ‘down’ depends on how much is realized on the sale of a current home.

Most people are on a fixed income in retirement. Hoped-for inheritances and lottery windfalls aside, there will likely be no new income sources or capital materializing in future. Once people begin to draw on a HELOC at this stage of life, it can be a one-way path. With no other way to allow them to eliminate the line of credit, it could end up as a hefty closing cost taken out of the proceeds on sale.

Ideally, this is a considered and conscious decision that allows an individual or couple to remain in comfortable, familiar surroundings for as long as possible. In fact, with informed planning, it can be a carefully controlled process of aligning money to milestones, be that downsized ownership, seniors’ rental, assisted living or long-term care.

So, whether it’s short-term or long-term, it’s best if there is a plan when contemplating a HELOC. Be clear at the outset what it is intended to bridge from and to, in terms of time, money and lifestyle requirements. Then, keep track of the accumulation, and be prepared for those next steps once your “to” is on the horizon.

Five ways to weather your way through your debt

Meteorologically managing your money

Credit is a great tool that helps us get established in life, but eventually our accumulated debt needs to be paid off. Easy enough said in principle, but for many people it’s tough to reverse the tap from accumulation to decumulation.

Most people come into debt slowly and steadily over many years. Expecting that it can be overcome quickly and effortlessly may not be realistic. You need to do three things:

- Wean yourself away from taking on more debt
- Make sure you are paying all the interest on what’s outstanding, and
- Pay down the principal owed to your creditors

Where to start

With that in mind, here are some meteorologically-themed strategies to begin dealing with your debt. These are not mutually exclusive so decide what best fits your sensibilities, and keep in mind that planning is nice but you need to commit to action, even if it’s small steps.

Your first step is to figure out what you reasonably need to live on each month while you tackle the debt, which will then tell you how much is available to knock down the debt.

1. Steady soak
– Even payments

The easiest arithmetic may be to just pay the same dollar amount to each debt, being sure that you’re above each creditor’s required minimum where extra interest or penalties may apply. Monitor it monthly (and otherwise don’t fret), and as the smaller items drop off, adjust the amount and reallocate among what’s remaining.

2. Sun showers
– Smallest first

Actively tracking many accounts can be mentally wearisome, and even physically draining. Instead, you could concentrate on your smallest debts one at a time, while paying the minimums on the rest. As you peel away those nuisance amounts, you build confidence in your abilities, freeing time and mental space to move on to the larger balances. As well, early and frequent victories will bolster your resolve.

3. Downpour
– Biggest first

It depends on you, but one of the biggest stress inducers for many people is simply seeing a large dollar figure. Your heart sinks each time you open your statement because you see and feel what seems like an insurmountable obstacle. By wiping out large chunks of this large chunk, you’re able to see beyond it to get perspective on your entire financial picture, and make visible headway toward reaching your goals.

4. Thunder and lightning
– Most costly first

If you ask the mathematical technicians, this is where you should begin. It can easily be shown that eliminating your highest interest debt is the fastest way to stem the flow required to service all of your debt. Once you’ve beaten down that most costly leakage, you can build on that momentum to aim at progressively easier targets. If you are driven by logic, this is the strategy with the strongest appeal.

5. All-weather solution
– Your habits

Again, the key is to get started, but it could be a fruitless exercise in the long run if you don’t know how you got to this position. While you trim your debt, consciously consider your past and present spending patterns and living habits. This can free up more cash for the cause while in the midst of debt reduction, and lay the groundwork to be in a more comfortable position to enjoy and sustain sunnier days ahead.

Deducting investment loan interest

Managing the tax aspect of borrowing to invest[1]

Investors may invest their own money, and may also borrow to put more money to work. Also known as ‘leveraged investing’, the presumed intention is to increase market exposure and multiply potential investment returns. Depending on market movement at a given time, that multiplication can work either for or against an investor, which is why such decisions should be discussed with a qualified investment advisor.

That advisor-investor discussion should focus first on how a planned strategy fits that individual’s financial circumstances, including objective risk tolerance and subjective comfort with risk. Attention can then turn to the tax issues, and in particular the rules for claiming interest expense as a tax deduction.

Requirements for deductibility

Interestingly, interest is not defined in the Income Tax Act (ITA), so case law has filled in that gap. Generally, it is compensation paid for the use of a principal sum, calculated on a day-to-day accrual basis. Less technically, it’s what a borrower pays for the use of a lender’s money.

When it comes to deductibility, the ITA deals with that in a roundabout way, first denying deductibility for interest in paragraph 18(1)(b), then setting out conditions to allow for exceptions to that denial in paragraph 20(1)(c).
The four key requirements follow.

1. Paid or payable in the year

Most taxpayers will deduct the amount of interest that accrues in relation to a year, but if a taxpayer uses the cash method of accounting then it is the amount actually paid in a year that may be deducted.

2. Legal obligation on borrower

A borrower records interest as an expense once all conditions for the legal obligation to make the payment have been met. If the payment is contingent on a future event then a deduction cannot be taken until that contingency has been fulfilled.

3. For the purpose of earning income from a business or property

The borrower must have a reasonable expectation that the investment will earn income, even if the income may be less than the interest expense. This requirement will be met if the investment is capable of earning income (whether or not there is income in a given year), but not if the investment is only able to produce capital gains.

4. Amount of interest must be reasonable

The reasonableness of the interest charge is determined with reference to prevailing market rates for debts with similar terms and credit risks. In an arm’s length transaction with a financial institution, the reasonableness will usually be obvious (though not guaranteed) by the commercial practices and documentation employed. In other cases a closer look at the circumstances may be required.

Application to marketable securities

Per the third requirement above, an investment may be made in either a business or property. Property may be either real property (more commonly known as real estate) or moveable property. Marketable securities fall into that last category of property.

Individual securities or mutual funds

Marketable securities include instruments like stocks and bonds, and may be either individually-owned or held as part of a pooled investment structure. Common pooled structures include mutual funds, exchanged-traded funds (ETFs), and segregated funds issued by insurance companies.

Qualifying account type: Non-registered

For interest to be deductible, the expected income must be taxable. Accordingly, the relevant type of investment account where the securities are purchased and held is a taxable account, also known as an open, cash or non-registered account.

Registered accounts

Interest is not deductible when a loan is used to earn income that is tax-exempt. Thus, no deduction is allowed when borrowing to invest in registered plans such as a registered retirement savings plan (RRSP), tax-free savings account (TFSA), registered education savings plan (RESP), or registered disability savings plan (RDSP).

This does not prevent a person from borrowing to fund such accounts, for example the practice of using RRSP loans, but rather it is a prohibition on deductibility of the associated interest when used in this manner.

Current use, and replacement property

It is the current use of the borrowed money that determines deductibility. On initial borrowing, the initial use and current use will be the same. Later transactions with the property can affect deductibility, depending on the value of the invested property, the outstanding loan balance, and how the proceeds are reallocated. *

When an original investment is disposed for an amount equal to the amount borrowed:

- If the entire proceeds are moved to one or more qualifying investments, then all interest charges will continue to be deductible.
- If the proceeds are divided among qualifying and non-qualifying property, deductibility will be limited to the proportion of the proceeds allocated to the qualifying investments.

If that original investment has grown in value relative to the amount borrowed, the investor has some flexibility in how the borrowing is linked to the replacement property.

- The investor may still choose to allocate the borrowing proportionately among the new properties.
- However, it may be advantageous to make a disproportionate allocation. Assume an original borrowed/ invested amount of $100,000 had grown to $150,000 when disposed, with the proceeds used to acquire qualifying investment “QI” for $130,000 and non-qualifying property “NQ” for $20,000. The investor may choose that the current use of the borrowed money is entirely for QI since its value exceeds the outstanding loan balance, allowing for continuing full deductibility.

Where the value of the replacement properties is less than the outstanding loan balance, a pro-rata allocation is required. Assume the original $100,000 borrowed/invested in the above example is disposed for $80,000, with $60,000 used to acquire QI and $20,000 used for NQ. The current use of the borrowed money would be $75,000 in a qualifying investment ($60,000/$80,000 x $100,000), limiting the deduction to 75% of the interest charges.

* In these examples, the gross proceeds are being used for the replacement properties, with any tax on capital gains (or recovered tax on capital losses) managed through an outside source/account. Alternatively, tax could be managed from within the investment, with the net proceeds reinvested. The numerical illustrations would be more complicated under the latter approach, but the investor’s net tax cost is the same either way, and the principles being discussed remain the same.

Drawing down investments

As with any investment held over several years, realized income will be distributed and taxed to the investor annually. Assuming growth over the long term, the holding at any given future date will be a combination of the invested capital – in this case originating from borrowed money – and the undistributed growth of the investment, which for tax purposes is the unrealized capital gain.

There are two tax issues that arise on disposition of the investment:

- A capital gain (or capital loss) will be triggered on a disposition. Though the tax calculation is no different whether the original money was borrowed or was the investor’s own source, it helps to first isolate and resolve the effect of the disposition, to then fully focus on what happens with interest deductibility thereafter.
- It is the actions taken after the disposition that affect interest deductibility. This is the application of the ‘current use’ principles above, illustrated below according to the way in which the drawdown occurs.

Lump sum disposition

If an investor disposes of an investment in full, tax will be due on the realization of the entire capital gain in that one year. The remaining amount received will be a non-taxable return of capital (ROC). (See our article “Capital gains taxation – Deferred, preferred and more” for a more detailed discussion of the associated tax issues.)

If the investor reallocates the proceeds from disposition of an investment to other property, the deductibility of any continuing interest charges will be governed by the principles outlined earlier. On the other hand, if the investor decides to use a portion of the proceeds to retire the outstanding loan balance, there will be no further interest charges and therefore no deductibility issues to contend with.

Periodic or systematic withdrawals

An investor may instead decide to draw the money out periodically as desired, or on a regular routine through a systematic withdrawal plan (SWP). Either way, each withdrawal will be a combination of ROC and realized capital gains. (See our article “Systematic withdrawal plans” for a more detailed discussion of the associated tax issues.)

Often the plan for such accounts is to allow them to accumulate undisturbed for a period, then to use a monthly or annual SWP to supplement personal finances later in life. Whether used to acquire capital property for personal use or to spend on personal expenses, this is effectively a reallocation of the withdrawn amount toward non-income earning purposes. As such, a portion of the continuing interest payments will no longer be deductible.

In the simplest case where there have been no prior withdrawals and no further contributions beyond the original investment, the non-deductible portion will roughly equal the ROC component of the withdrawal divided by the outstanding loan. (A qualified tax professional should be consulted to verify the facts and perform the calculation.) However, the investor may preserve deductibility on future interest charges by paying down the loan by the corresponding amount, such that the remaining debt continues to be linked to an income earning purpose.

ROC on ‘t-series’ mutual fund distributions

Some mutual fund managers allow investors to receive a fixed annual distribution out of their mutual fund holdings using a t-series distribution. The “t” refers to tax, and specifically that such distributions may enable the deferral of tax on unrealized capital gains within the mutual fund.

The manager allows the investor to choose a single digit distribution percentage, usually in the 4% to 6% range. The rate is applied to the investment balance at the beginning of the year to arrive at equal monthly payments made over the course of the year. At the end of the year, the manager tallies up the fund’s performance and reports what portion of those payments were distributions of realized income, with the remainder being ROC.
For some mutual funds there may be no realized income, such that the entire year’s payments may be ROC.

Being a return of the investor’s own capital, the ROC portion is tax-free. Though appealing in the current year, the trade-off is that the investor’s adjusted cost base (ACB) is reduced by the amount of the ROC distribution. This means that a greater proportion of each future investor withdrawal will be taxable, as the realized capital gain part of a withdrawal is the difference between the fair market value of the withdrawal and its proportionate ACB.

As with a periodic withdrawal or SWP discussed above, the effect on interest deductibility depends on what the investor does with the distributed amount. To the extent that it is used for personal use property and spending, future interest deductibility will again be trimmed down. Importantly however, the degree of effect may be much larger on a t-series distribution due to the larger ROC proportion, potentially being the entire annual withdrawal. (Once more, ROC does not necessarily equal the at-risk amount of a loan. Consult a qualified tax professional.)

Managing and servicing the loan

Principal repayments

Pursuant to the first two requirements for deductibility above, the borrower must make interest payments and be legally obliged to do so. Invariably the borrower will also have a legal obligation to pay the principal back to the lender, either on a fixed schedule, at the end of the loan term, or in whatever manner the parties may agree.

Principal repayments do not entitle the borrower to a deduction, though they do reduce the amount of the outstanding loan on which future interest will be calculated.

Compound interest

By agreement or through a lender’s concession, a borrower may be allowed to forego an interest payment in a year, with the amount then added or ‘capitalized’ to the principal debt. As the borrower will not have paid interest in respect of that year, no deduction will be allowed at that time for the capitalized amount. A deduction will be allowed as interest is paid on the outstanding balance in future, as long as all other requirements are met.

Taxpayer onus, recordkeeping, and linking sources & uses of borrowed money

Once the decision is made to proceed with a leveraged investment strategy, an investor must understand that the onus is on that person as a taxpayer to prove entitlement to tax benefits, in this case the deductibility of interest on investment loans. Given the range of issues canvassed in this bulletin, it should be clear that an investor carries a substantial burden in meeting that onus.

Often, a single loan advance may be used to purchase qualifying investments in a single account. Alternatively, that advance may arrive in a temporary holding account which is then allocated to a combination of places, possibly all deductible (at least at first), or a combination of deductible and non-deductible purposes. A degree further in complexity might be the use of a line of credit for these various purposes, from which future draws are taken, interest charges paid, and principal amounts repaid.

Whatever form the borrowing may take, good organization and good recordkeeping will allow an investor to better monitor and evaluate the effectiveness of the borrowing strategy. That also sets the stage for both tax reporting and tax-based decision-making.

[1] For more information, readers may consult Canada Revenue Agency Income Tax Folio S3-F6-C1, Interest Deductibility.