Excerpt from The Financial Navigator – Converting Non-deductible Debt to Deductible Debt
Although this book primarily deals with incorporated professionals, there may be some readers who for some good reason are not incorporated. If you find yourself in this situation and have personal debt, you might want to consider what is sometimes referred to as cash damming.
The basic principle behind cash damming is converting personal debt into business debt, in order to benefit from tax-deductible interest. If you’re running your practice as a proprietorship and you’re paying for eligible business expenses with your professional income, you’re allowed under the Income Tax Act to borrow money to pay for your business expenses and deduct the interest.
So instead of paying your professional bills, such as rent and liability insurance, out of your earnings and paying your mortgage with after-tax dollars, borrow the money to pay your rent and use the money you save to pay down your mortgage.
This strategy can work with any personal debt.
Suppose you’re a new grad and have $200,000 owing on a student line of credit and an annual income of $175,000 pre-tax. The interest on your student line of credit is non-deductible. If you ask the bank, they should be willing to give you a $50,000 unsecured51 line of credit. It’s been my experience that Scotiabank and Royal Bank will normally do this at prime52, if you’re a physician, or a dentist.Use your new line of credit (LOC) to pay all your business expenses. If your business expenses average $3,000 per month, you would add $3,000 to your new LOC every month (this would free up $3,000 per month from your income) and then use the “extra” $3,000 per month to pay down your student LOC.
At the end of the first month your student LOC would be down $3,000 and your new LOC would be up $3,000. What you’re effectively doing is moving the debt from non-deductible to deductible. This reduces the overall interest cost.
If you’re in a 40 per cent tax bracket and paying five per cent interest, you now know from a few pages ago, that you have to earn that much more to pay it, if the interest is non-deductible. If we take the example of $1,000 of interest, it looks like this: in a 40 per cent tax bracket you have to earn $1,666.66 to pay the $1,000 in interest. If the interest is deductible, you have to earn $1,000 to pay $1,000.
If you have a good working relationship with your bank, you should be able to move all your non-deductible debt to deductible debt over time because the overall credit being extended isn’t increasing. As a matter of fact it’s decreasing at an accelerated rate because you’ll be paying it off faster.
Degrees of Separation
Have you ever considered how much distance there is between you and your money? For instance, when you invest in your practice you have complete control over its operation and in particular the expenses you incur – the degree of separation between you and your money is effectively zero.
On the other hand when you put your money in a bank, you could say that the degree of separation has increased by one. You probably won’t lose any sleep over this, but what about when you invest your money? How distant are you from your money, when someone else is investing it on your behalf?
This is not purely a philosophical point I’m making. Think about it – the more people involved in handling your money the more people who get a slice of the action. One way or another these people need to get paid. And, who do you think is paying them?
One thing I can tell you is that in many cases it’s the manufacturer of the product (e.g. the mutual fund, or segregated fund company) who gets paid first; you, the investor, are going to be second or third in line.
My best advice when considering investing money is that the best investment you can make is in yourself. If you have an opportunity to buy a practice, or a building that houses your operation, then that is where you should invest. If you have an opportunity to buy a new piece of equipment that will increase your bottom line, then that is where you should invest. You’ll have more control over these types of investments than handing your money over to someone else. If you are going to invest through other people, make sure you get paid before they do. I’ve always found it intriguing that people are willing to invest, with little or no expectation of income. When you buy a practice, you’re anticipating an increase in your income. When you buy a building, you’re expecting an income, or at the very least a reduction in your costs. When you invest in new equipment, you’re doing so to improve your productivity. So, why is it different when you invest your money with someone else? Whether it’s your stockbroker, or your insurance agent, your banker, or your mutual fund representative, they all know and expect to be paid to invest your money, but you have little or no immediate expectation of income. Your expectation is that when you need the money there will be more in the pot than when you first invested. But, is that realistic? I suggest that for more and more people this is not the case.
It all comes down to watching the bottom line; what are my investments worth, versus what income are my investments producing? Over the years most people lose track of how much money they’ve invested, so have no idea what their real rate of return is. I realize that some statements do show the original investment amount, but if you have moved brokerage firms in the past, or have reinvested income, the amount shown may be inaccurate. By watching the income from your investments, the amount invested and the value of those investments is less important and easier to monitor.
If you’re going to hand your hard earned money over to someone else to invest on your behalf, why shouldn’t you get paid before they do? You’re the one taking the risk. It’s your money isn’t it?
Getting paid first can mean receiving interest, dividends (eligible and other than eligible), rental income, or royalties. It doesn’t have to be any one of these in particular, but it should be one, or more, of them if you can find the right investments. Now, does it make sense to expect something from your investments regardless of what the current market value is? I certainly think so, and last time I checked so did Warren Buffett, Donald Trump and Jimmy Pattison.
Let’s take a quick look at two of what I call “manufactured products” – mutual funds and segregated funds. First let’s look at a couple of facts; around 50 per cent of Canadians own mutual funds, and in November 2011 Canadian mutual fund assets totalled some $773 billion…