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Understanding the Cash Damming Technique

28 March 2019 by National Bank
Mise à part de l’argent

Are you self-employed, or do you own rental property? The cash damming technique could allow you to deduct your personal loan interest from your income. Find out how.

Cash damming allows you to reduce your taxes by reimbursing your business expenses via a personal loan whose interest gradually becomes deductible.

To put it simply, it means turning debt interest that is non-deductible into interest that is deductible. Converting personal debt into business debt, the interest of which is fully deductible, allows you to generate savings that will allow you to reduce your non-deductible debt, such as the mortgage on your home, for example. 

Who can use this strategy?

First of all, it’s important to note that only rental property owners, self-employed workers who are not incorporated, sole business proprietors and the partners of a general partnership can employ cash damming as a tax strategy. 

Cash damming can be used by rental property owners. They must open two accounts: one for their rental income and the other for all expenses related to the building. Then they must simply link this second account to a personal line of credit that will be used to pay for the expenses. The interest on the credit line will thus be deductible the next time you file your income taxes. 

It’s in a self-employed worker’s best interest to properly plan their finances and to keep taxes in mind all year long. Cash damming is a strategy they can use to lower their taxes

Self-employed workers cannot deduct personal loan interest from their income tax. But cash damming does allow them to convert their mortgage interest into deductible interest, thus decreasing their tax bill significantly. 

What are the prerequisites?

If you’re self-employed or a rental property owner and you’re thinking about cash damming, here are the other things you will need:

  1. A bank account for your business income
  2. A bank account for your business expenses
  3. A non-deductible debt or personal loan
  4. A credit line that’s used exclusively for your business operations

Two accounts are better than one

While you can save a significant amount of money with cash damming, the first step is to establish a clear and precise plan. So rather than keeping everything in one account, it’s better to open two separate ones: one for your revenue and one for your expenses.

A self-employed worker or rental property owner would then be able to dip into their entire income to pay for their expenses or pay off their personal debts. At the same time, they can use loans, like a credit line, to deal with all of their business expenses. And the higher these expenses, the faster the conversion.

How to save $80,000

If you have a $200,000 residential mortgage with an amortization period of 25 years with an interest rate of 6%, you could save over $80,000 in taxes.

How? If you pay $1,288 every month, you will have paid nearly $386,600 over 25 years. So, the deductible interest will amount to $186,600 ($386,600 - $200,000). With a tax rate of 45%, you will therefore save $83,700.

Too good to be true?

Don’t worry. For self-employed workers and rental property owners, cash damming is 100% legal. Tax and financial authorities, including the Canada Revenue Agency (CRA), have recognized this as a valid technique since 2002. 

To help you understand how cash damming works, the Centre québécois de formation en fiscalité has made available a handy document on taxes called La technique de la mise à part de l’argent (French only), which includes many examples and lots of information. 

But be vigilant

Make sure however that you fully understand how it works and what steps to take so you don’t end up with nasty surprises.

Also, beware of mortgage repayments for your home if you separate from your partner: there will be additional costs related to dividing the house. If you have commercial buildings, GST and QST payments could also complicate your ability to cash dam. That’s why it’s best to meet with a financial advisor before you use this strategy.

And be patient, because your personal net debts won’t change overnight. Bankers generally recommend cycles of 3 to 5 years when it comes to cash damming. You just have to reorganize your spending and be disciplined. 

 

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