# Which mortgage to lump sum?



## jamesbe (May 8, 2010)

There was another thread here: http://canadianmoneyforum.com/showthread.php?t=10304

Which was very similar but was focused on Investing. My question is slightly different. I'm debating which mortgage I should be lump-summing on.

I have a rental, mortgage is $110k currently, 4.39% fixed with 2.5 years left on the term. I pull in about $200 a month profit and payment is $509 a month for mortgage. I can pay about $10k a year extra on it without penalty.

My personal home mortgage is $340k at 2.15% variable, 5 years left on the term but can pay up to $70k a year extra on it without penalty.

I've got about $50k cash I could drop on either of these within the next few months. If I waited 2.5 years when the rental comes for renewal I could potentially just pay it off completely. Or I could put the money on my principal residence.

Of course the mortgage on the rental is tax deductible so this is causing me a dilemma, and the mortgage rate on my principal mortgage is so low it seems silly to pay extra on it until the rates rise.

I was thinking if the rental property was paid off I'd have about $700 a month income (or maybe $400 after taxes) I could then put that on my principal residence. Of course until everything is paid off or the terms renew my monthly income does not change.

Thoughts?


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## the-royal-mail (Dec 11, 2009)

As long as this won't affect your emergency fund I would say just go with whatever makes you feel best. In my own case I would tend to pay off the smaller loan first so that it's off the books. It's always good to get debt off the books.


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## iherald (Apr 18, 2009)

You get a tax write off for the rental mortgage. But why not put $10 towards the rental property and $40 towards the home mortgage. 

I always figure at the end of the day you need to have a place to lay your own head.


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## houska (Feb 6, 2010)

jamesbe said:


> I have a rental, mortgage is $110k currently, 4.39% fixed with 2.5 years left on the term. I pull in about $200 a month profit and payment is $509 a month for mortgage. I can pay about $10k a year extra on it without penalty.
> 
> My personal home mortgage is $340k at 2.15% variable, 5 years left on the term but can pay up to $70k a year extra on it without penalty.
> [...]
> Of course the mortgage on the rental is tax deductible so this is causing me a dilemma, and the mortgage rate on my principal mortgage is so low it seems silly to pay extra on it until the rates rise.


A bit of tangent, but are you using the full potential tax deduction? Sounds like you're deducting the interest on the $110k mortgage but not on the $340k. We had a similar situation, where our mortgage on the rental property was about 50% of the equity. When we financed our principal residence (new purchase), our financial advisor helped us carve out part of *that* mortgage and deem it as funding the holding of the rental property, and the interest on that then became tax deductible. Establishing the money trail to satisfy an eventual CRA audit needed some attention to the details, of course, to clearly show that the use of this money was to own the rental even if the loan is secured against our principal residence.

Illustrated with (fake) numbers:

Option A
$250k rental, $110 mortgage A secured against rental, tax deductible
$500k principal residence, $340k mortgage B secured against it, not tax deductible

Option B
$250k rental, $110k mortgage A, tax deductible
$500k principal residence, $140k mortgage B1 secured against residence but tax deductible because the proceeds are used to fund the balance of equity in the rental. $200k mortgage B2 (at same rate) not tax deductible.


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## jamesbe (May 8, 2010)

Interesting.... Didn't know I could do that.

Although the rental's total worth is about $170k at most so I'm not sure if it is worth it for that much. I'd have to break mortgages to do this though, would I not?


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## Elbyron (Apr 3, 2009)

In order to satisfy the CRA's requirements for deductibility of mortgage interest, you would have to do some pretty crazy manoeuvres. First you would have to sell the rental to a trusted person, perhaps in exchange for a promissory note. This would break the mortgage on the rental and incur fees, unless you wait until the 2.5 years is up. The proceeds of the sale would go toward your home mortgage, though you can only pay down $70K per year without incurring huge fees so it may take a few years to use it all up. Step 2 would be to take out a new mortgage in order to buy back the rental. If have sufficient equity in your home, you can also take out a line of credit to pay for the mortgage down payment. The interest on the new mortgage and the HELOC would become tax deductible. You end up with 100% of the rental property's value held in tax-deductible loans, and your non-deductible home mortgage is significantly reduced. To tidy things up, the trusted person uses the proceeds of the 2nd sale to pay back the promissory note. 

Of course, it's a little more complicated than this, and land transfer taxes may be quite costly depending on your province. You would have to make sure that the extra tax deduction will eventually pay for all these taxes and all the legal fees.


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## jamesbe (May 8, 2010)

Yeah no thanks. LOL back to the original. Maybe on the next rental


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## houska (Feb 6, 2010)

You are right, probably not worth it in your case due to having to break several mortgages. 

In our case, we were accidental landlords - we bought a new house but for a variety of reasons couldn't unload the condo we had lived in and so needed to keep it as a rental for a few years. Also fortuitously the mortgage on the condo was maturing in the same month as we were taking possession of our new home. With professional help and a co-operative lender we were able to arrange everything a bit more easily than in Elbyron's email while still having the appropriate money trail. But you are correct, would probably not have worked except for some fortuitous circumstances. 

Nevertheless, worth keeping in mind that if one has a mortgage on a principal residence as well as owning rental properties, than with the proper strategy quite likely part of the principle residence mortgage can be made deductible - just may or may not be worth the hassle.


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## OhGreatGuru (May 24, 2009)

Since the rental is cash-flow positive and the interest on the rental mortgage is tax deductible, I would suggest paying down the principal residence mortgage. It will considerably improve your personal financial risk.


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## balexis (Apr 4, 2009)

If it were me, I would run the numbers and see which option is better financially first. Yes rental interests are deductible, but in and of itself it is not a decision factor.

jamesbe: try and find an Excel mortgage calculator and play with it. Don't forget to take into account the $ you save with the interest deduction based on your marginal tax rate and you'll get the net effect of paying down one mortage or the other.


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## Four Pillars (Apr 5, 2009)

OhGreatGuru said:


> Since the rental is cash-flow positive and the interest on the rental mortgage is tax deductible, I would suggest paying down the principal residence mortgage. It will considerably improve your personal financial risk.


I'm going to side with OGG. 

The higher rate on the rental is a bit of a red herring, since it will reset in 2 years anyway and then the two properties will have a similar rate.


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## Mall Guy (Sep 14, 2011)

I am in a similar situation, and have decided to keep the mortgage prepayment on the rental at a minimum (want to run the income on rental as close to a zero tax based profit as possible) while reducing the after tax (non-deductible) mortgage payments. 

The other strategy is to pay out the max on the rental, and re-mortgage to the max in 2.5 years, and use the proceeds to pay off non-deductible mortgage, likely equals out, or use proceeds for other rental/property investments.


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## Eclectic12 (Oct 20, 2010)

jamesbe said:


> [ ... ]
> 
> Which was very similar but was focused on Investing. My question is slightly different. I'm debating which mortgage I should be lump-summing on.
> 
> ...


If you pay down your personal mortgage - your taxes stay the same.

If you pay down the rental mortgage - your taxes increase at your income rate.

If you invest - depending on what the investment is, your taxes can be any combination of the same, increase at a preferred rate or increase at the income rate.


IMO - if the emergency fund has already been taken care of, a combination of the personal mortgage and investing (preferably in a TFSA) is what I'd do. I'd use tax preferred dividend income to pay down the rental mortgage.

Assuming a 40% tax rate plus converting to pre-tax dollars, today the rental is being paid pre-tax (i.e. $1) so I'd prefer to use investment income (i.e. something like $1.20) or capital gains (maybe $1.18) to pay it down instead of money taxed as income (i.e. $1.40).


Or if you want to hedge your bets, put part against all three.


Cheers


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## Plugging Along (Jan 3, 2011)

Mall Guy said:


> The other strategy is to pay out the max on the rental, and re-mortgage to the max in 2.5 years, and use the proceeds to pay off non-deductible mortgage, likely equals out, or use proceeds for other rental/property investments.


Unless the laws have changed, one cannot just remortgaged an investment property and put the money against their principle mortgage and still have it deductible. There are ways to do this, but the above is not one of them.



In terms of what we have done, we have choosing to pay off our non deductible mortgage instead of the rental properties. The reasons are partially the tax deductibility, but also, even though ou do have a higher rate on the investment, I feel the lower mortgage ou have n our house, the less risk you re at.


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## Elbyron (Apr 3, 2009)

Plugging Along said:


> Unless the laws have changed, one cannot just remortgaged an investment property and put the money against their principle mortgage and still have it deductible. There are ways to do this, but the above is not one of them.


The laws have not changed, you still cannot claim interest deductions on a loan whose proceeds are directly used for a non-deductible purpose. It doesn't matter what property is used for the loan collateral, it only matters what the loan money gets used for. 


> With professional help and a co-operative lender we were able to arrange everything a bit more easily than in Elbyron's email while still having the appropriate money trail.


Houska, though it may be a tangential topic, I'm interested to learn more about how your financial advisor was able to set up a money trail that satisfies the requirements for interest deductibility without having to sell the property being converted into a rental. This is something I have studied extensively and have only ever heard of the solution I mentioned previously.


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## houska (Feb 6, 2010)

Elbyron said:


> Houska, though it may be a tangential topic, I'm interested to learn more about how your financial advisor was able to set up a money trail that satisfies the requirements for interest deductibility without having to sell the property being converted into a rental. This is something I have studied extensively and have only ever heard of the solution I mentioned previously.


Elbyron - I will look it up. I am travelling on a different continent from my financial records and this was several years ago, so I don't remember the details. It was a bit more complicated, in that we also had an investment portfolio that we collapsed, used to purchase the house, and then reborrowed against the equity to repurchase most of the portfolio back. The trail consisted of getting the order right between advancing bits and pieces of the different mortgages, liquidating and then repurchasing the portfolio, and paying for the house. It helped that it was all the same financial institution and all on the same day.


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## Elbyron (Apr 3, 2009)

houska said:


> Elbyron - I will look it up. I am travelling on a different continent from my financial records and this was several years ago, so I don't remember the details. It was a bit more complicated, in that we also had an investment portfolio that we collapsed, used to purchase the house, and then reborrowed against the equity to repurchase most of the portfolio back. The trail consisted of getting the order right between advancing bits and pieces of the different mortgages, liquidating and then repurchasing the portfolio, and paying for the house. It helped that it was all the same financial institution and all on the same day.


Yeah, I guess I can see how that would work as long as your investments were at least as large as the new mortgage on the condo. It would likely have been a 2-part shuffle: sell investments to buy new house, and mortgage/re-finance the condo to buy back investments. The interest on the condo mortgage would then be tax deductible, because its funds were directly used to purchase investments. The only problem with this workaround is that things start to fall apart if you try to sell the investments and use the proceeds for any non-deductible purpose. The supreme court ruled that it is the current use, not the original use, of borrowed money that is used to determine the deductibility of interest. So if you were to sell off $10K to pay for some home renovations or a vacation, your "current use" becomes split between the investments and the expense, and your loan is only partially tax deductible. I've heard of people keeping paperwork to show the split and justify their proportional deduction, but this can get complicated with compounding interest and especially tricky if you make extra payments to the loan or re-finance it. It's best not to risk getting screwed in an audit, so if the above is the workaround that you used, I would suggest you maintain the investment (and do any further buying/selling in a separate account if possible) until you are ready to sell the whole thing, at which point the condo mortgage is no longer tax deductible.


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## houska (Feb 6, 2010)

Elbyron said:


> [...]I would suggest you maintain the investment (and do any further buying/selling in a separate account if possible) until you are ready to sell the whole thing, at which point the condo mortgage is no longer tax deductible.


Thanks Elbyron. Indeed, I understand that withdrawing any money for other than investment purposes from an investment account that is supported by a tax-deductible investment loan is somewhere between a really bad idea and a really big mess. As far as we are concerned, our condo is sold now (and the proceeds were with clear paper trail moved to our leveraged investment account). We are in accumulation mode and don't foresee withdrawing from this account, until and except in a situation where we would no longer feel comfortable having a leveraged market position anyway.

My learnings from all of this are
a) Importance of clear paper trail that shows that money borrowed for investment purposes has throughout its lifespan been used exclusively for that purpose
b) Realization that if one has somehow ended up with both tax deductible and non tax deductible debt, and has at the same time investments not wholly funded by tax deductible debt, then you are leaving some value on the table. It may or may not be worth jumping through the hoops to optimize it, but it's worth considering (probably with professional advice) especially around any refinancing opportunity.


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## Sampson (Apr 3, 2009)

I think the two accepted ways in Canada are:

The Smith Manoeuvre (described in some detail by houska)
or
the cash flow dam (described here by MDJ)


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