July 11, 2007, 3:15 am

Double Dipping: Another Leverage Recipe Part 1

by: The Financial Blogger    Category: Leveraging Strategies
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While most people think that finance is boring and includes only small-nerdy-brown-socks-accountants (sorry guys!), there is a real World of Willy Wonka behind the scene. Financial magicians are working hard day after day in order to create the most powerful and smart financial strategies. As we have financial engineering taking care of financial products, we have several financials planners creating amazing personal finance techniques. Today I will outline the basic principals of the Double Dip. This may not be the official term, but I like to use this one as it appears to be a good representation of what it allows you to do. This may be they only time where double dipping is permitted!

The Double Dip was issued from a combination of two financial products. The first one is the investment loan (yet again, another leveraging strategy!) and the other one is the RRSP. Where are you dipping? And even more important, where are you double dipping? Patience, we are getting there.

A well-known advantage of the investment loan is the tax deduction related to the interest paid on the loan. In fact, The Canadian Government allow you to deduct all interest paid on a loan that was used to invest and produce an income. Therefore, you can reduce your gross earned income with your interest bill.

The same tax principle is applicable on RRSP contributions. Actually, the full amount of the contribution can be used to decrease your earned income. The only limitation you have is set at 18% of your previous year income. Keep in mind that your unused contributions can be carried forward indefinitely.

I don’t know if you are seeing what is coming next but we are finally getting to the double dip strategy. Let’s assume that your marginal tax rate is 40% and the interest rate on your loan is prime (6%…. for now…shoot it just has been changed yesterday for 6,25%). By signing for a 100K investment loan, you will pay $6,000 in interest each year. Therefore, your tax return associated to your investment loan will be $2,400. You net interest cost will be $3,600.

Once you have received your tax return in the mail, you take that $2,400 and make an RRSP contribution. Next year’s tax return will grow up to $3,360. Why is that? You will still have $2,400 from your investment loan deductible interest and another $960 from your $2,400 RRSP contribution. By double dipping in the Government’s taxation laws, your net interest cost after one year will be $2,640.

Therefore, you are reducing your interest rate risk related to the investment loan while building a RRSP account that could benefit from tax deferment. If you keep on double dipping, your tax return will increase along with your RRSP contribution. The only thing that will decrease is your net interest cost on your investment loan. I think we all want that! I’ll write another post with full calculation later on. In the meantime, you can ask me questions or work out some numbers.

 

***part 2 of the technique is now ready here!***

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Comments

by: Len Currie | July 11th, 2007 (7:42 am)

Hmm…. great idea.. now to figure out how to go about making this work with the Smith Maneuvre to maximize tax savings.. triple dipping? ha ha ha.. jk.

this 2x dipping seems to be legit.
i have a similiar question regarding 2x dipping; how do treat the interest on the investment loan?
1st, as in your ex, we’ll get a tax refund of $2400 becuase this is the interest of the loan.
my question is this: what happens when i sell the investment? can i again claim the interest as an expense? (eg, similiar to buying stock using a broker. i can claim the fee as my expense.) if so, this will increase my average cost of the investment and therefore decrase my captial gain (assuming gains :p) and hence reduce tax.

by: The Financial Blogger | July 11th, 2007 (2:59 pm)

Len,
I think you just have a great idea for the Triple Dip 😉
I’ll check if it possible and get back with another post if it is the case!

J,
For all leveraging strategies, the interest is deductble as long as the investment (and the loan) is in place. If you sell your investment and not reimburse your loan, the interest on the loan is not tax deductible anymore. Accordging to CCRA, the interest on a loan is deductible if funds were used to buy investment in a perspective of receiving an income. If you sell this investment, you will no longer expect any income. Therefore, the strategy ends up there.
Cheers,
FB.

I’m not against leveraged investing in general, but $100k might be too risky for the faint at heart.

by: The Financial Blogger | July 12th, 2007 (2:47 am)

Hi FJ,
the amount you should leverage greatly depends on two major factors:
First is the amount of cash flow that is available to you (and knowing that interest rate could rise as it is the case now in Canada).
Second, you must not leverage more than half your net worth.
So technically, 100K suits people with great cash flow and net worth of at least 200K (and I am not counting car for net worth as it is a highly depreciating asset).
I usually use 100K as it is a round number, maybe I should consider changing my example for 50K, it would make more sense for several people… good point!
FB.

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