Strategy guide

The Debt Swap

How Canadians with non-registered investments make part of their mortgage deductible on day one, with the same payment.

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Make part of your mortgage deductible on day one

A lot of Canadians have a mortgage and a non-registered investment account at the same time. They're paying non-deductible interest on their home while their savings sit in investments next to it. A debt swap rearranges those two so part of the mortgage becomes a deductible investment loan, without changing your payment or your total debt.

The gap most people miss

It feels like borrowing against investments you already own should make the interest deductible. It doesn't. For tax purposes, what matters is what the borrowed money was used for. If you borrowed to buy your home, that interest stays personal, no matter what else you own.

A debt swap changes what the money is used for. Instead of a mortgage that bought your home and a portfolio bought with savings, you end up with a smaller home mortgage and a portfolio bought with borrowed money.

The rule it's built on

Interest is generally deductible when borrowed money is used to earn income from property, like dividends or interest. CRA's Income Tax Folio S3-F6-C1, Interest Deductibility and Canadian court decisions look at the direct use of the borrowed funds, which is why the order of the steps matters so much: sell, pay down the mortgage, then borrow and buy.

What changes, and what doesn't

You owe the same total amount. Your combined mortgage payment stays the same. You still own a similar portfolio with the same exposure to the market.

What changes is the label on part of your debt. That slice is now an investment loan, and its interest comes back to you at tax time. Put those refunds on the rest of the mortgage every spring and it's paid off sooner, with the same payment.

What it can cost

Selling investments can trigger capital gains tax on whatever has gone up in value. Sometimes that makes it worth swapping only part of the portfolio, or spreading the swap over more than one year. There may be trading costs, and if your mortgage isn't up for renewal, restructuring it can come with a fee or penalty.

If any holdings are sitting at a loss, buying the same investment back within 30 days can trigger the superficial loss rule and deny that loss. Your accountant and advisor can work around it.

After the swap

A swap converts a chunk of the mortgage in one go. Many people then carry on with the Smith Manoeuvre, so the rest of the mortgage converts a little more every month as it's paid down.

The walk-through

A debt swap, step by step

A debt swap happens mostly in one go, over a few days. The order of the steps is what makes the interest deductible, so it's worth knowing exactly how it runs.

Before you start
Take stock of your investments

Only non-registered investments work. RRSPs and TFSAs don't. For each holding, you'll want to know what you paid and what it's worth today, because selling can trigger capital gains (or losses) that change the math.
Set-up
Get a mortgage that can be split

The mortgage needs to be able to hold a separate investment portion, usually a readvanceable mortgage. If your mortgage isn't up for renewal, Mitch checks whether it can be restructured without a penalty.
Day one
Sell and pay down

The non-registered investments are sold, and the cash goes straight onto your mortgage. For a moment, you owe less and own less.
Day one
Re-borrow and buy back

The same amount is borrowed again from the investment portion and used to buy investments in your non-registered account. You end up with the same total debt and a similar portfolio, but that slice of your debt was borrowed to invest, so its interest is generally deductible.
Every spring
Claim the interest, use the refund

Interest on the investment portion is claimed as a carrying charge. The refund goes onto the rest of your mortgage, which shortens it with the same payment.
Down the road
Keep converting

Many people follow a swap with the Smith Manoeuvre, so the rest of the mortgage converts a little more every month.

Common mistakes

Wrong order. Sell, pay down the mortgage, then borrow and buy. Borrowing against what you already own doesn't count.
Forgetting the tax on selling. Selling can trigger capital gains, and buying back a loss within 30 days can cancel it.
No tracking. Keep the statements for the sale, the paydown, the borrowing and the purchase.

Is it a fit?

A debt swap is the quickest of the strategies to set up, but the details matter.

Good fit

You have investments outside an RRSP or TFSA
You own your home
You have at least 20% equity in it

Probably not yet

Your investments are all in registered accounts
Selling would trigger a large capital gains tax bill
You'd rather use the money to pay the mortgage off for good

Debt swap questions

Anything about your own tax situation should also go past your accountant.

Why does this make the interest deductible?

Deductibility depends on what borrowed money is used for. Today your mortgage was borrowed to buy your home, so its interest isn't deductible. After the swap, the new portion was borrowed to buy investments that earn income, so its interest generally is. The order of the steps and a clean paper trail are what make it work.

Does my payment or total debt change?

No. You owe the same total amount, split into two portions on the same amortization, and the combined payment is the same.

What does it cost to do?

Any tax on gains when you sell, trading costs, and possibly a fee to restructure the mortgage. Enter your estimate in "Fees and tax to sell" to see the result after those costs. If your mortgage isn't up for renewal, Mitch will check whether it can be split without a penalty.

Am I out of the market while this happens?

Only briefly. The sale, the paydown and the re-borrowing are usually done within a few days. Your advisor can time the trades to keep that window short.

How is this different from the Smith Manoeuvre?

The Smith Manoeuvre converts your mortgage gradually, as you pay it down. A debt swap converts a chunk on day one using investments you already own. Many people do the swap first and then carry on with the Smith Manoeuvre.

See it on your own numbers

Bring your mortgage statement and a rough idea of your investments. In 15 minutes Mitch will tell you whether a swap fits and how your mortgage would need to be set up.

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