Borrowing to invest in Canada. A compelling case for early retirees.

IMG_1968

Trying to cook steak and asparagus over a fire at a local beach in Sooke, BC (we didn’t really come prepared lol turned into a medium rare steak because the wood holding the grill collapsed before we could cook it any further).

 

Borrowing to invest in Canada.

A compelling case for early retirees.

So you have maxed out your RRSP and TFSA and your Spouses RRSP and TFSA (and possibly your close family members TFSA). What do I invest in now (tax free)? Well if you own your home with substantial equity it may makes sense to make that equity work for you. Especially if a substantial amount of your net worth is real estate. Diversify!

I live in Victoria, BC where the average home is just over a million dollars. That’s a lot of equity that potentially is wasted. So it may be a smart idea to diversify, take some of that equity and invest it in 3,600+ companies (VUN.TO) as opposed to have it tied up in one asset. Okay lets jump into the numbers

Example

Borrow $250,000 from your home through a cash out refi at 3.5% and invest the proceeds in a low dividend well diversified ETF such as VUN.TO.  Let’s see what could happen over the next 10 years. Short answer is you would make $198,896.75 net profit for about 5 hours of work. Which would include seeing a mortgage broker, going to a notary’s office and setting up the investments with a company such as Quest Trade.

Requirements are:

  • Own your home with enough equity (generally can not borrow more than 80% equity)
  • Have steady employment income and good credit rating to qualify.
  • Have maxed out TFSA and RRSP
Years1
Initial amount2
Interest charged on mortgage 3.5%3
Dividends made (VUN.TO) 1.5%4
CRA tax refund5
Capital appreciation
conservative 6% per year6
Total growth from dividends  and CRA tax refund minus interest charges7
Net profit8
1-10
$250,000
$46,657.60
$37,500
$3,205.16
$454,849.18
$448,896.75
$198,896.75

 

After ten years you could cash up to $24,000 capital gains a year (without any other income) and not pay any taxes. This is because our personal exception amount is approximately $12,000. Capital gains are taxed at 50% so therefore, we can take up to $24,000 a year without paying any taxes as long as that is our only taxable income. In this example our capital gains are $204,849.18 (capital appreciation minus initial amount) over the hypothetical ten-year period. If we take $204,849.18 and divide it by $24,000 that will give us a rough number of years we can retire without paying taxes. In this case the answer is 8.54 years. Of course the real number may be closer to 12-13 years because the fund continues to grow as well as paying out dividends but for this example I’ll stick to 8.54 years. So we take the total growth and divide it by 8.54 years to give us the maximum amount we can with draw per year without paying a single cent in tax (as long as it’s your only income). This number is $52,939.33 per year! This is because 24,000 of the $52,939.33 is capital gains and the rest is our original investment.  Once the capital gains draw down period is over (8.54-13 years or longer depending on market conditions) than you can start to with draw from the RRSP and TFSA. If a recession were to occur during those 8.54-13 years you could draw down from the TFSA (or possibly RRSPs) as well. So it makes sense to keep a small portion of your TFSA or RRSP in safe investments like Bonds and perhaps REITs.

Anyways, this is an interesting and practical option to provide tax free income for at least the first 8.54 years of early retirement. It’s far more practical for the early retiree than the “smith maneuver” because the interest rates are generally lower on a cash out refi (same rates as a conventional mortgage) than a readvanceable mortgage such as a HELOC. Also the paper trail is very clear if you ever get audited by the CRA. Additionally, the readvanceable mortgage  never gets paid down, which can be a negative if you retire early as it will be more difficult to refinance or switch mortgage providers when income is from investments.

5CRA tax refund explanation. The CRA allows you to borrow to invest. The interest on borrowed funds is entered on line 221 on your tax return. This interest is used to reduce your total income, including employment income.  A tax rate of 35% was used for the calculations. On paper you would have a net loss for the next 10 years as long as you don’t sell your investments and realise the capital gains.  You can see the interest charged was greater then the dividend payout therefore on paper you have a loss every year because of this, the CRA will give you a tax refund based on your tax bracket.

This is a more advanced strategy that applies to specific situations. Please consult a fee based advisor and/or a CPA with any investment plans. Let me know in the comments if this helped or informed your early retirement plans.

 

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s