Beware of mortgage tax deduction claims
Earlier this month, the Supreme Court of Canada issued a decisive ruling that clarifies once and for all that the interest paid on a mortgage taken out to purchase a principal residence cannot be tax deductible under any circumstances (unless part of the house is used for business purposes.)
The ruling in the case of Lipson v. Canada relates to a complicated series of transactions put into place by Earl and Jordanna Lipson back in 1994.
Initially, Jordanna borrowed $562,500 from the Bank of Montreal to buy shares in her husband's company at market value. She paid the proceeds of the share purchase loan directly to her husband.
The next day, the couple bought a home for $750,000 and obtained a Bank of Montreal mortgage on it for another $562,500. Right after the house closing, the Lipsons used the proceeds of the mortgage to pay off the share purchase loan completely.
In 1994, 1995 and 1996, the husband deducted from his taxable income a total of more than $104,000 in interest expenses on the mortgage loan.
The Minister of National Revenue disallowed the deductions and reassessed Lipson accordingly. The government's position was that the complicated series of transactions amounted to "abusive tax avoidance."
In this country, evading tax is illegal, but avoiding tax is – generally – acceptable, except when the avoidance is abusive. If the minister believes a tax avoidance scheme is an abuse and misuse of the Income Tax Act, the government can invoke the general anti-avoidance rule (GAAR) and deny the taxpayer's claimed deductions. That's what happened in the Lipson case.
When his deductions were disallowed under the GAAR rules, Earl Lipson took the minister to Tax Court, then the Federal Court of Appeal and ultimately, the Supreme Court of Canada.
In a 36-page judgment with two separate dissents, the Supreme Court sided with the government and the two lower courts in a 4-3 ruling.
The Lipson case may have serious ramifications for taxpayers who use schemes like the Smith Manoeuvre to attempt to convert the interest on their principal residence mortgage to a tax-deduction.
The seductive pitch for the Smith Manoeuvre on the promoter's website, www.smithman.net, reads, "Go ahead, make your mortgage tax deductible. Yes, it can be done. Yes, it's legal."
The essence of the Smith Manoeuvre strategy is that each month the homeowner pays down a little bit of the principal owing on the home mortgage, and then borrows it back. The borrowed money is then invested and the carrying charges on that newly borrowed money only are tax-deductible.
But, according to Melanie and Robert McLister at canadianmortgagetrends.com, "it's not for everyone. There are both investment risks and serious tax risks. Your (investment) returns could be insufficient, CRA (Canada Revenue Agency) could invalidate your application of the strategy, or you could wind up in a negative amortization scenario if your house value falls."
(A negative amortization occurs when the balance owing on the mortgage exceeds the value of the house.)
In my opinion, strategies like the Smith Manoeuvre are far too risky for the average homeowner.
After the Lipson decision was released, tax specialist Dan White wrote me to say that taxpayers simply "cannot convert their mortgage to tax-deductible interest. The final verdict is in. ... The primary purpose of an activity dictates the final results in tax deductibility.
"They can borrow money against their house to invest and write off the interest ... so long as it is not just a manoeuvre."
Anyone tempted to participate in the Smith Manoeuvre or other strategies to try and make interest on a home mortgage tax-deductible should obtain tax advice from a qualified accountant or tax lawyer who is not selling anything except unbiased advice.
Tax advisers who make a commission from selling participation in schemes like the Smith Manoeuvre may be in a conflict of interest and their advice may not be impartial.
Above all, taxpayers should not be misled by promises, which appear to make all their home mortgage interest tax-deductible.
Bob Aaron is a Toronto real estate lawyer and a director of the Tarion Warranty Corporation. He can be reached by email firstname.lastname@example.org, phone 416-364-9366 or fax 416-364-3818. Visit the column archives at http://aaron.ca/columns/toronto-star-index.htmfor articles on this and other topics.