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Would leveraging the equity in a home to invest in dividend-paying investments lead to tax repercussions?
I wish to leverage my HELOC to invest in dividend-paying investments. How would you advise I approach this? Is this an effective tax savings tool? Is there any financial institution or products you would advise?
—Martha
You know, Martha, in some circles, leveraging—or borrowing to invest—is a taboo subject. I find that funny because there is much less controversy when people borrow to:
So, why is there controversy around borrowing to invest? It is probably due to a lack of understanding, coupled with the fact that when leveraging goes bad, it’s not good.
Let’s talk about leverage. If you borrow $100,000 at 8%, what rate of return would you have to earn on your investments to break even? Would you guess 8%?
Most people would agree with that answer; it sounds logical, right? I mean, if you borrow $100,000 at 8% and paid $8,000 in interest costs then that would mean you would have to make $8,000 on your $100,000 investment to break even, which is 8%. Got it? Good.
But that answer may be wrong depending how you invest.
The break-even return on investments may be lower than the borrowing cost when you take into account if you consider the way a tax deduction works and the way non-registered investment income—depending on the type of income—is taxed.
In Canada, when you borrow money to invest, the interest cost is considered a carrying charge on your income tax return. That creates a tax deduction no different than an registered retirement savings plan (RRSP) contribution. Looking at this in concrete terms, if your marginal tax rate is 30%, your after-tax cost of borrowing is 5.6% on a 8% interest rate, well almost.
It is not quite that simple. It also depends on the length of time you hold the investments and the investments annual distributions. Let me give you an example using Talbot Stevens Leverage software, which you can download for a free 30-day trial.
If you have a marginal tax rate of 30% and borrow $100,000 at 8% over 10 years to invest in a regular mutual fund, in Talbot’s software, your break-even investment return is 6.2%. Extend the time frame to 20 years and the break even is 6.1%. Increasing the marginal tax rate to 40% reduces the break-even return to 5.6% over 10 years and 5.4% over 20 years.
As you can see, the tax efficiency of your investments can impact the net benefit of borrowing to invest. The less tax you pay on your investments as they grow, the more money you have invested, and the more the returns can compound over time. Assuming you are paying the tax from your investment account.
If you borrow at 8% and invest in 8% guaranteed investment certificates (GICs) (I know, where can you get an 8% GIC?), you won’t come out ahead. That’s because interest income you earn is fully taxable. Sticking with our 30% marginal tax rate example, if your after-tax cost of borrowing from above is 5.6%, your after-tax cost of investing in GICs at 8% would also be 5.6%. You’d pay 30% tax on the 8% interest income earned.
If you invest in stocks, there may be an advantage, though.
Only 50% of a capital gain is taxable. Even then, not until you sell. And if you invest in Canadian stocks, there is a tax credit for Canadian dividends called the “dividend tax credit” that leads to a lower tax rate as well that varies with your income.
With that in mind, do dividend-paying investments make sense? What’s your reason for selecting dividend-paying investments? Is it because you feel those investments are safe and provide good returns? That’s an OK reason, but if you could find investments with a similar level of risk and rate of return which paid less in distributions/income, then you may be better off from a tax perspective.
Were you thinking of using the dividends to pay some of the interest charges? You can do that, but I would advise against it. Don’t do leverage unless you can easily make the interest payments out of your regular cash flow.
When you borrow money using a home equity line of credit (HELOC), you pay interest to the lender. Typically, the interest rate on a HELOC is variable. That means the cost of borrowing rises and falls based on the lender’s prime rate, which in turn is influenced by the Bank of Canada’s policy interest rate (also called the benchmark interest rate). The policy interest rate is currently 3.75%. A HELOC interest rate is usually the prime rate plus a percentage—for example, “prime plus 1.5%.” –MoneySense editors
A HELOC is a home equity line of credit. Here are a few things Canadian investors should consider before borrowing any money to invest:
Finally, when it comes to leverage don’t think just about investment accumulation but also think about how you can use the interest tax deduction. Here are a few quick thoughts:
Still skeptical? I encourage you to download the free trial of Talbot Stevens’ leverage software to see for yourself. (Here is a demonstration of the software.)
I hope I’ve given you some things to think about, Martha, and I haven’t made it look like everyone should run out and start leveraging. If you have the cash flow, borrow within your means, stick to a broad market investment, and have a long-time horizon, you’ll greatly improve your odds for success.
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