Borrowing to Invest Can be Advantageous to Your Wealth

Contributed by Tim Cestnick

Managing Director, Tax Smart Services at AIC in Burlington, Ontario

A Companion Advisor Article

With interest rates close to 40-year lows, the concept of borrowing to invest is a strategy worth considering in building your long-term wealth. Prudent borrowing, and wise investment of the proceeds, can lead to significant wealth creation over time.

The key is to invest in good quality assets that will stand the test of time. A well-managed, diversified mutual fund avoids the risk of investing in a single business. Borrow only an amount that you can comfortably carry, and that won’t cause you anxiety should your investments suffer a temporary decline in value.

Leverage is a powerful tool that cuts both ways. If you borrow to invest, whether you have gains or losses on your holdings, the effects will be magnified.

For example, if you put $100,000 into a mutual fund – using $25,000 of your own money and a $75,000 loan – and the fund gains or loses 10 per cent or $10,000, that would actually be a 40 per cent gain or loss on your original equity – before loan costs.

There are also tax considerations that should be understood by investors contemplating a borrow-to-invest strategy. The Income Tax Act has rules that apply to the tax deductibility of interest, including:

• There must be a legal obligation to pay interest (a loan agreement signed by you confirming the interest charges you agree to pay and when).
• The amount of interest must be reasonable. Canada Customs and Revenue Agency (CCRA) will accept the use of public lending rates charged by the banks.
• The purpose of borrowing to invest must be to earn income from a business or property. For example, borrowing to invest in a business or piece of real estate that provides monthly cash flow would qualify. Investing in stocks and bonds, or mutual funds that generate returns in the form of interest, capital gains or dividends would also allow the interest expense to be tax deductible.

Interest is Tax-Deductible

Typically, you can borrow to invest at the current prime rate, plus one to two percentage points. However, for an investor in the top tax bracket, with deductibility of loan interest costs, the actual cost would be about half.

Remember that only half of any capital gains realized on your portfolio are taxable as income. And even if the value of your investment increases, a taxable capital gain is not actually triggered until the holding is sold or a manager realizes gains within the portfolio. If your mutual fund doesn’t pay a taxable distribution, you may deduct annual borrowing costs from your other income.

Generally, the higher the portfolio turnover, and the more tax you pay annually, and the higher the overall return needs to be for you to make money after borrowing. Low turnover means that realized gains are kept to a minimum, and taxable distributions are minimized, allowing more of your capital to work for you.

Important Variables Affecting Returns

There are four key variables that affect your ultimate returns:

• Interest on your debt;
• Type of investments you hold;
• Your marginal tax rate; and
• Your investment time horizon.

Generally, borrowing to invest is considered an aggressive strategy that requires careful evaluation with a financial advisor. An advisor can help you determine the suitability of investments for a borrowing strategy. Investments must be able to generate an after-tax investment return that is greater than the after-tax interest cost.

I would suggest the possibility of restructuring your finances if you currently have non-tax-deductible debt such as a home mortgage or a car loan, while also owning taxable investments such as stocks, bonds or mutual funds. You may be able to pay down your mortgage or car loan, and borrow against your investments instead.

By converting your non-tax-deductible interest expense into tax-deductible debt, you can reduce your overall borrowing costs.

For more information on this subject, consult with your Fiscal Agents representative or call (905) 844-7700.

Tim Cestnick is a well-known tax columnist and author of the best seller Winning the Tax Game, and Managing Director of Tax Smart Services at AIC Group of Funds.