Any problem with this SM strategy

[iamdogdog]

Hi all, this is how my friend implements his SM:

I personally think there is a problem, but he said he has been doing this for the past 3 years, and he still havn't heard anything from RevCan yet.

Here is what he did. Use HELOC to withdraw 200k, invest it in some kind of fund, of which will distrubute monthly distrubution(e.g. 8% per year), and 80% of this monthly distrubtion is in the form of return of capital, so he only need to pay tax on the other 20%. He then claim off the entire interest on the 200k loan on each year tax form.

My question: Since this is his third year now, his original ACB is no longer 200k, and is it still ok for him to claim the full interest being charged on 200k?

Thanks.

[pitz]

Here is what he did. Use HELOC to withdraw 200k, invest it in some kind of fund, of which will distrubute monthly distrubution(e.g. 8% per year), and 80% of this monthly distrubtion is in the form of return of capital, so he only need to pay tax on the other 20%. He then claim off the entire interest on the 200k loan on each year tax form.


And he spends the distributions? What happen with the distributions? Return of Capital, in and of itself, wouldn't necessarily give rise to a loss of deductibility, if the money was re-invested to replace the investment capital that was depleted.

Its really a grey area from what I've seen. But if he's using the distributions to pay the interest on the HELOC, or if he's using the distributions to buy more securities, then he's definitely on 100% solid ground insofar as interest deductibility.


My question: Since this is his third year now, his original ACB is no longer 200k, and is it still ok for him to claim the full interest being charged on 200k?


Maybe, maybe not. To be 100% safe, he should only consume the actual *income* of the investment account for non-deductible purposes. If he's using the distributions to pay interest, or to re-invest, then I personally don't see absolutely anything that the CRA could remotely challenge.

It has been theorized that if you borrow to invest in something that pays out ROC, unless you apply that 'returned capital' to your loan balance, or to new investments, deductibility of a portion of the original loan ceases. I've never heard about anyone being nailed though on that basis, and as long as its not obviously and blatently abusive...

[iamdogdog]

hi pitz,

opps, forgot to mention that he put his distrubution back into his mortgage, just like regular SM.

[pitz]

hi pitz,

opps, forgot to mention that he put his distrubution back into his mortgage, just like regular SM.

Yeah that could be problematic then.

[iamdogdog]

So this is not a sound strategy I can follow, right?

My feeling is RevCan will probably look at your investment when your ACB is zero(like 13 years later), then they can ask you back for all the interest you have deducted. Am I missing something here? Where should I go ask for a "rock solid" answer for this?

Thanks.

[pitz]

So this is not a sound strategy I can follow, right?


To avoid a potential problem with ROC, I'd advise that you use funds that primarily either pay income or dividends.

Sure, it will take longer to convert all of your debt into being non-deductible. But its more likely to stand the test of time compared to a fund that pays mostly ROC.


My feeling is RevCan will probably look at your investment when your ACB is zero(like 13 years later), then they can ask you back for all the interest you have deducted. Am I missing something here? Where should I go ask for a "rock solid" answer for this?



Well there's nothing wrong with a zero ACB. But if you deplete the capital of an investment made with borrowed money, I would suggest that the ability to deduct that borrowed money also dissappears, unless you use the returned capital to buy new investments (as opposed to using such money for non-deductible things such as paying off a non-deductible mortgage).

[cloudycanada]

It is a very grey area......will the CRA challenge it? no answer

He did use the HELOC to purchase investments .... and reported income. But the return of capital should have been put towards the HELOC .. since that's where the money came from.

For example, I can't just borrow 100, buy something, sell it for 120 .... and put all 120 towards my mortgage and continue to deduct the interest expense on the $100........that is very likely an abuse of the income tax act and will be challenged. You friend is basically doing the same thing, over time, when he puts return of capital towards his mortgage.