Can you slash your income tax?

At some point when you’re wading through your tax return for the umpteenth time looking for ways to trim your tax bill, you are likely to hear a tiny internal voice whispering that maybe, just maybe, it’s time to get a little more aggressive. Why not claim your gym membership and magazine subscriptions as business expenses? (After all, you have to be fit and well-informed to perform your job.) Why not write off that European vacation as a research trip? (It certainly gave you insight into emerging trends in French wines and German beer.) Why not indulge in some of the fancy manoeuvres that the truly rich use to reduce their taxes?

The answer is that the taxman is a tough opponent. Despite what you may think, there are no gaping easy-to-use loopholes that you can use to make your taxes magically shrink. In fact, the system is designed to leave most salary-earning middle-income families with very little discretion when it comes to toting up their tax bill. Gym memberships, magazine subscriptions and European vacations definitely fall into the prove-it category. Unless you’re successfully self-employed and able to demonstrate that such expenses are an integral part of your business, the taxman isn’t going to be impressed.

Does that mean you just have to sit back and take whatever the tax authorities decide to dish out? Not at all. If you truly want to cut your tax bill, a few strategies allow you to substantially reduce the amount you pay. These strategies are perfectly legal, but they typically require professional advice to set up, and you should weigh the cost of the advice against the tax savings before deciding if the strategy is worthwhile. Some of these tax manoeuvres also involve hidden pitfalls that you must be careful to avoid. Still, if you truly want to cut your tax bill, these aggressive strategies may be just what you’re looking for.

Mortgage magic

The idea

Jim has a mortgage of $150,000 on his home. He also has an investment portfolio of $180,000. His accountant tells him that he can’t write off interest costs on his mortgage, but he can write off interest costs on loans he takes out for investment purposes. So Jim gets an ingenious idea: why not sell his investment portfolio, use the proceeds to pay off his mortgage, then borrow the same amount of money to buy back his investments? It seems to him that this shift should leave him with the same amount of debt he has now, but allow him to deduct the interest on his loans from his taxable income.

The pitfalls

This strategy is not only perfectly feasible, it’s actually recommended by some financial planners. However, if you’re going to give it a whirl, don’t skip any steps. For instance, if you have a portfolio of stocks you own outright, as well as an existing loan that you used to buy a boat, you can’t just start claiming that the loan was really taken out for purposes of buying the stocks. To make your loan tax-deductible, you have to actually sell your stocks and pay taxes on your capital gains (which can be substantial if you’ve held your investments for a long time). You then have to pay off your boat, take out a new loan and repurchase your stocks. And don’t count on being able to claim a capital loss for investments that have fallen in value since you purchased them. If you sell an investment at a loss and repurchase the same investment within 31 days, the tax department will assume you’re trying to create an artificial loss and deny your claim.

How to make it work

Wait until your mortgage comes up for renewal to avoid penalties. Follow all the steps to the letter — sell your investments, pay down the mortgage, and then borrow to repurchase the investments. If you sell your investments at a loss, make sure you wait at least 31 days before repurchasing the same investments, or buy something different.

Who it makes sense for

People who have an investment portfolio as well as a mortgage or other consumer debt.

A debt defying feat

The idea

Marilyn has heard about a book written by Fraser Smith, a financial adviser in Victoria, that promises to make her mortgage tax-deductible. Unlike the Mortgage Magic strategy above, the so-called Smith Manoeuvre doesn’t require that you have an investment portfolio as well as a mortgage. All you need to do is to shop around for a credit line that’s set up with separate “subaccounts” to track both deductible and non-deductible debt.

With that in hand, you begin the process of shifting your borrowing from areas that aren’t tax-deductible to areas that are. Let’s say that Marilyn has a $300,000 mortgage, which she replaces with a line of credit. Let’s also assume that Marilyn’s first monthly payment of $1,500 reduces the principal of her non-deductible home loan by $300 (the rest of the payment goes to pay the interest on her loan). As soon as her home loan goes down, she then re-borrows $300 from the credit line to purchase investments, thus making the interest on this portion of her debt tax-deductible. Every time Marilyn makes a mortgage payment, she increases her investment loan accordingly. Over several years, her total debt remains $300,000, but the tax-deductible proportion of her borrowing steadily increases.

The pitfalls

In a word, risk. Your debt level never decreases and if your portfolio suffers a setback, you wind up with the worst of both worlds — lots and lots of debt as well as big losses on your beaten-up investments.

Barbara Garbens, president of B L Garbens Associates Inc., a financial planning firm in Toronto, suggests that most people should approach the Smith Manoeuvre with caution. “Most people want the peace of mind that comes with being debtfree. Who’s to say that there won’t be another market crash, or that clients won’t lose their jobs and be on the hook for thousands of dollars in debt, deductible or not?”

How to make it work

Make sure you can stomach the risk and stress involved in living with lots of debt. Choose your investments carefully — excess risk is a recipe for disaster. Finally, make sure the records on your credit line document the deductible and non-deductible portions of interest paid.

Who it makes sense for

People who are comfortable with risk and already have a large mortgage, but no investments, may want to explore the Smith Manoeuvre, but should be aware of the dangers.

A home run … maybe

The idea

Brad, a highly paid executive, and Sharon, a stay-at-home mom, own their own home in Ottawa. Not only does Brad’s salary put him in the top tax bracket, he’s built up a substantial investment portfolio that generates income of about $30,000 a year. He wants to get some of his income into Sharon’s hands where it will be taxed at a lower rate, so he decides to buy Sharon’s share of the family home. He will pay her by putting his investment portfolio in her name. Brad and Sharon figure they’ll save a bundle by having the investment income from their portfolio taxed at Sharon’s minimal level rather than at Brad’s highest rate.

The pitfalls

The plan can work, but a transfer of ownership with assets changing hands must “really be dressed up properly” to withstand a challenge from the authorities, says Keith Rosen, tax partner at the accounting firm of Stern Cohen LLP in Toronto. Brad can’t just ask his broker to move $400,000 from his investment portfolio into Sharon’s name, and assume all is well. If assets are changing hands, a change in title on the property must be registered, and in Ontario, the spouse selling her share has to pay land transfer tax. (The exact rules on land transfer taxes differ from province to province.) Brad and Sharon also need to file a statement known as an “election” with their tax returns so that Sharon will be able to claim the investment income from the money she’s receiving.

There are other potential problems. If Brad’s investments have gone up in value since he bought them, he will have to pay capital gains tax on his profits. But things don’t work the same in reverse. If there’s a loss on his investments, the tax department won’t allow Brad to claim it on his tax return because of the spousal relationship between him and Sharon.

How to make it work

Consult a professional. Before you commit yourself, add up all the costs involved (legal fees, land transfer tax, potential capital gains tax) and make sure that the tax savings are worthwhile.

Who it makes sense for

Couples who make dramatically different amounts of money and who will save enough in taxes to outweigh the legal and accounting costs.

The downsizing dance

The idea

Steve and Maria are on the verge of retirement. Both of them have worked for years, although Maria has accumulated a much larger investment portfolio than Steve. They plan to sell their home, which is now worth about $500,000, and buy a smaller country property for $300,000. Their plan is to take the money from the sale of their current home and split it down the middle. Then, when it comes time to buy the country property, they’ll engage in some fancy footwork. Maria will put $250,000 towards the purchase, while Steve will contribute only $50,000. They figure this will leave each of them with equal-sized investment portfolios, which will effectively split their investment income and reduce their tax bill.

The pitfalls

This is a workable strategy, says Rosen, although he points out “the burden of proof is always on the client” when dealing with tax authorities. If challenged, Steve and Maria need to prove that Steve contributed to the original downpayment for the purchase of their first home as well as mortgage payments. Otherwise, some of the income and gains on his investments would be taxable in Maria’s hands.

How to make it work

Check that both you and your spouse contributed to the purchase of the first property and that you have the paper trail to support that claim. Consult a certified financial planner for help in determining how best to divvy up the capital.

Who it makes sense for

Couples who have very different incomes and intend to sell their home upon retirement.

Build your own tax haven

The idea

Suzanne earns $100,000 a year in her work as a marketing executive and is looking for ways to reduce her taxes. She’s heard that if she sets up a sideline business from home, she can write off the expenses related to the business and reduce her overall taxable income. Suzanne has always had an interest in photography, and figures if she could sell a few pictures, she should be able to write off her equipment, her home office/studio, and maybe even her travel expenses.

The pitfalls

“Not so fast,” says Sylvia Sarkus, a certified financial planner in Toronto. It’s quite legitimate to write off business expenses against your income from the same business, but you can’t write off expenses on your self-employment sideline against your taxable income from other sources (like your day job) indefinitely. Posting losses for three consecutive years or longer is a definite red flag for the tax authorities. Sarkus advises self-employed clients to show a profit, however small, rather than continue to report losses. In particular, a taxpayer is specifically not allowed to use home office expenses to create or increase a business loss.

How to make it work

If you have a skill in an area such as photography, carpentry, or making snowshoes, and you’d like to make some money from it, make sure you structure it as a business. Consult an accountant about the types of expenses you should be documenting. Your goal should be to earn some extra income tax-free, rather than to reduce tax on your other sources of income.

Who it makes sense for

Budding entrepreneurs or those who would like to turn a hobby into a source of income.