Mortgage – Doug Carroll

RRSP mortgages and interest deductibility

At issue

Generally a mortgage secured against real estate in Canada is a qualified investment for an RRSP. An annuitant may even choose to hold a mortgage on his or her own property, though the qualification criteria are more stringent in such situations.

Essentially, where annuitant and debtor are not at arm’s length, the Income Tax Act requires that the mortgage be administered by an approved lender and that it must carry mortgage insurance. While there are costs associated with these requirements, in a high interest rate environment a RRSP mortgage may be preferable to making payments to a commercial lender, as the interest contributes to the RRSP’s investment return.

Of value to those with rental properties, in the right circumstances it is possible to also deduct interest charges on those mortgage payments made into one’s own RRSP.

CRA 1999-9926175E – Mortgage as a Qualified Investment

The CRA author provides a rundown of the principal sections in the Income Tax Regulations under which a mortgage may be a qualified investment for a RRSP. Though the relevant sections have since been amended and consolidated, the substance remains effectively the same today.

Included is an admonition that an annuitant cannot benefit from the existence of the mortgage. In support, the letter goes on to state that “the mortgage interest and other terms must reflect normal commercial practices.”

In context, this reinforces the purpose of the lender and insurance rules, and should not be taken to suggest that there can be no other benefits whatsoever, such as for example potential interest deductibility where a rental property is involved.

CRA 2011-0413761E5 – Interest

This CRA letter comments on a hypothetical scenario whereby a taxpayer’s RRSP uses a non-arm’s length mortgage to retire an original loan from an arm’s length bank used to purchase some rental properties. It confirms that “as long as the rental properties continue to be held by the taxpayer for the purpose of earning income from a business or property”, interest on this second loan – now held by the RRSP – will indeed continue to be deductible.

Duxbury v. The Queen, 2006 TCC 688

To invest in a business, the taxpayer borrowed from a commercial lender by mortgaging his jointly-held home. Some years later as part of a creditor protection exercise, his RRSP used a mortgage to retire the arm’s length mortgage. At the same time, the house was transferred into his wife’s name alone.

In a subsequent year, the taxpayer sought to deduct the annual mortgage payment as an RRSP contribution for that year. CRA denied this claimed deduction, and its position was upheld in this taxpayer appeal.

Given that the original borrowing had been for a business purpose, the interest would have originally been deductible. Depending on how the RRSP acquired its mortgage from the commercial lender, some or all of that deductibility could potentially have carried through to the RRSP mortgage. Unfortunately, there is no mention in the judgment of the interest component as distinct from the full mortgage payment, so it is not clear whether the taxpayer could not advance this argument based on the facts, or if the issue was simply not raised.

Practice points

The cost of non-arm’s length RRSP mortgages becomes more palatable in higher interest rate environments.
One is not precluded from deducting interest where a rental property or underlying business purpose can be shown.
Good recordkeeping will assist in tracing the use of funds, particularly where a substitute loan is employed.

Neither borrower nor lender – Litigating a faulty RRSP mortgage

While not common today, it has long been possible to hold your own mortgage within an RRSP. Particularly in a high interest rate environment, there is certainly an appeal to feeding high monthly mortgage payments into your own RRSP — rather than to your favourite lending institution.

On a practical level, however, clients must still partner up with a qualified lender. This can be costly to establish, cumbersome to document and complex to administer — and even then, mistakes can arise.

A recent Alberta case highlights just how much can slip through the cracks, and for how long. It also underlines the fact that failing to act diligently to correct an institution’s error may be fatal to a later claim in court.

RRSP mortgage rules

A mortgage on real estate in Canada can be held in an RRSP, and need not be a first mortgage, or even a residential mortgage.

However, when the mortgagor of the property is the RRSP annuitant or other non-arm’s-length relation to the annuitant, special administrative requirements must be observed. In such circumstances, the mortgage must be administered by an approved lender under the National Housing Act (NHA), and carry NHA insurance or other approved private insurance.

So long as the interest rate is commercially reasonable and the mortgage is administered in an arm’s-length manner, the arrangement complies with RRSP rules.

A misplaced mortgage

In a trial before the Alberta Queen’s Bench early in 2011, a claimant sought compensation from the institution with which he had attempted to establish an RRSP mortgage in 2002.

The $181,000 mortgage advance mistakenly came from another business unit of the institution, rather than out of the individual’s RRSP. As a result, the monthly mortgage payments were directed to that other unit, at “an inordinately high 7.5% interest rate for nearly five years.”

In the interim, the individual claimed to have obtained confirmation from the institution that he was entitled to trade stocks with the balance showing in his RRSP. This balance should, in reality, have been advanced on the mortgage.

Much stock trading followed, with the account almost doubling before settling back to $231,000 (including a transfer-in of $31,000 from another RRSP) by mid-2007, when a new home was purchased. It was at this point that the mistakenly-advanced mortgage error apparently came to light.

The institution admitted the error but defended the damage claim, in part based on the verification clause requiring customers to report statement errors within 30 days. The judge ruled that, in the face of its own negligence, the institution could not then demand strict compliance with that clause.

At the same time, the judge was not very sympathetic to the claimant’s plight, underlining that “the duties of fair and accurate reporting go both ways,” including the duty “of an ordinary bank customer, which would be to report promptly and reasonably an obvious error on his monthly statement.”

The judge ultimately characterized the individual’s claim as an attempt to obtain “a ruling that the bank save him from his own investment decisions.” Other than reversing a prepayment penalty, the judge denied the claim, holding that had the individual “left the account alone and not manipulated it,” he would have been entitled to compensation for unpaid interest, which totaled to about $63,000.

Oops, did I just say that?

As unfortunate as the litigation loss may have been for the individual, there may be more legal woes ahead. When pressed on examination as to whether a $298,000 single stock purchase was a risky investment strategy, he responded, “Not with the information that I had. I had a friend that worked there.”

One is left to wonder whether this also may have played on the judge’s sentiments in the final determination.

Tax talk on the dock – 5 planning points for an investing skeptic

I had the opportunity to catch up with an old friend by a dock earlier in the summer.

He is a true entrepreneur who took a calculated risk, established a successful business, sold to a multinational, had a brief retirement (at age 40) and a few years later is looking for the next challenge.

With those buyout funds in hand, he observed the recent economic turmoil with much skepticism about market investing. Actually he was a skeptic well back in time, and those funds never left the safety of his bank account. Even so, he knows he can’t remain on the sidelines forever.

So as summer comes to a close, here is what we threw about, apart from the horseshoes and mosquito swatter.

Run a business, if you are so inclined

My friend firmly believes that true wealth is built through active business management. And given his track record, I can’t disagree that a well-run enterprise can net impressive results – emphasizing the requirement to be well-run.

In actuality, he is something of a zealot when he extols the virtues of running a business, and more specifically the benefits of running a business through a small business corporation. He is living proof of the value of the small business rate, spousal income splitting and the lifetime capital gains exemption. Heck, he almost bubbles over in recalling the joys of a well orchestrated salary-dividend mix.

However, running a business is more than merely a financial decision, whether tax-driven or otherwise. In many ways, it’s a lifestyle choice, and has to be undertaken with that aspect clearly in focus.

Kill the mortgage

There is perhaps no more clearly predictable rate of return on applied money than to eliminate a big debt like a mortgage. Somewhat ironically, that kind of arithmetic certainty dovetails well with the more nebulously measured emotional comfort of being mortgage-free. Hey, it’s your home.

In his case, he had already achieved this prior to the business buyout.

That’s not to say that he was pursuing mortgage retirement to the exclusion of retirement savings. Rather, he placed more proportional emphasis on the mortgage than any raw calculus might explain.

Now being free of that debt burden, he is committed to becoming more knowledgeable and effective in fashioning his retirement income plan.

Getting 20% upfront on your RESPs

As people within the financial service sector, sometimes we forget that those outside the field have things on their mind other than the nuances we see much more regularly.

For instance, my friend was not even aware of the 20% Canada Education Savings Grant he was receiving on his RESP contributions. Thus, he was only contributing paltry amounts well below the $2,500 limit upon which the current year’s entitlement would be maxed out.

On the positive side, now that it is possible to pick up past years’ unused room, he will be able to get up to $1,000 CESG annually by putting in $5,000 for each of the kids until he catches up. Yes, he’s the same skeptic about market investments, but that’s a whopping tax/support benefit left on the table if that CESG is not unclaimed.

It remains to be seen whether he is inclined to make any further use of the RESP tax sheltering room beyond the CESG entitlement thresholds.

We differ on life insurance

While we are roughly on the same page that life insurance is a top priority matter for income replacement purposes, beyond that we diverge a bit.

He waffles on what to do with current life insurance, given the lack of an income replacement need. In not so many words, he defines that need in terms of whether his family would suffer a drop in lifestyle should he be removed from the equation. In that context, I agree that he does not need to replace income.

That said, terminal taxes and final debts loom, distant though they may be in the future. A tax-free death benefit may make sense to service that eventuality. Past premium payments are water under the bridge, and future premiums continue to be priced based on an earlier age.

A consideration of the internal rate of return of continuing premium payments may prove fruitful. That’s the kind of analysis an entrepreneurial business mind can appreciate.

Do the Wills

Actually they have done their Wills, but that was well before the business came to together and was later harvested.

The tax benefits of testamentary trusts may have been a passing topic in those earlier estate planning discussions, but now the benefits are very real – for the couple, the kids, and who knows who or what may come up in summers ahead.