This article was originally published on November 20, 2017. We have since made updates to it based on relevant, new information. We’ve also added a video and podcast episode that articulates the content in the article.
What Is the Cash Dam and How Does It Work?
Cash Dam is a simple but powerful concept to help you make your mortgage tax-deductible if you own either a small business or a rental property. It’s an especially attractive option if you are familiar with the Smith Manoeuvre or other tax minimization strategies. Cash Dam (sometimes referred to as the “cash flow dam” is a pure tax strategy without investment risk that does not require any of your cash flow.
What is cash damming?
The Cash Dam allows the owner of a small business or rental property to more quickly convert the mortgage on their home into a tax-deductible mortgage. It’s a variation on the Smith Manoeuvre, but without investing. The Cash Dam is essentially an expedient way to change bad debt into good debt.
The Cash Dam involves using a line of credit to pay your business expenses. Then you use the increased business cash flow to pay down your ordinary non-deductible mortgage or loan. The result is an increasing tax-deductible business credit line, while paying down your non-deductible mortgage or loan. The Cash Dam will only work if you own a non-incorporated personal or partnership-based small business or a rental property.
Is it legal?
The Cash Dam is specifically allowed by the CRA. It is explained in the Income Tax Folio S3-F6-C1, Interest Deductibility. You are allowed to segregate your borrowing into separate accounts, so you can trace which borrowing is for a tax-deductible purpose and which is not.
The critical issue is that you need to be able to trace the amount borrowed to a tax-deductible purpose and be able to show that the “current use” of that borrowed money is still for the tax-deductible purpose.
To understand the concept, if you could not find a tenant for your rental propety for a full year, you would just borrow to pay all the rental expenses. If you keep that separate from other borrowing, you can deduct the interest as a rental expense.
Now if you do have rent, you can use the gross rent for any purpose, such as paying down your mortgage, while continuing to borrow to pay all your rental expenses.
You own a small non-incorporated business that has $2,000 in expenses each month. You also have a readvanceable mortgage on your home with a credit line (HELOC) linked to your mortgage. The $2,000 per month business expenses could be paid by the home equity line of credit (HELOC). You then use the additional $2,000 cash you have because you did not have to pay your business expenses to make extra payments on your non-deductible mortgage. Each extra payment of $2,000 gives you $2,000 additional credit in your credit line to pay the next months’ expenses.
Interest paid on money that’s borrowed for business expenses is tax-deductible. By using the Cash Dam, you’ll be left with a growing tax-deductible business credit line and a non-deductible mortgage that’s been quickly paid down.
One of the keys to the Cash Dam, however, is capitalizing the interest on the business line of credit. Use your Cash Dam credit line to also pay its own interest. That way, you avoid using any of your own cash flow.
Best Real Life Example
A great example is Tony, a client that is a general contractor without a corporation. He has $1 million in sales from construction contracts that he gets done with $800,000 of sub-trades and a $200,000 profit. He has a large $800,000 mortgage on his own home because he did major renovations on it.
For Tony, the Cash Dam was extremely advantageous. We helped him get a readvanceablbe mortgage on his home. He used $800,000 of his sales to pay off his mortgage in one year, while using a credit line linked to his mortgage to pay the $800,000 in subtrades.
In just one year, his entire $800,000 mortgage became an $800,000 tax-deductible business mortgage!
In most cases, this process takes years as the owner of a small business or rental property slowly uses his gross sales or rent to pay down his mortgage, while borrowing from the linked credit line to pay all business expenses. The credit line interest is also a business expense.
How does the Cash Dam differ from the Smith Manoeuvre?
The Cash Dam and Smith Manoeuvre both convert your mortgage into tax-deductible mortgage over time. However, the Smith Manoeuvre also allows you to buy investments without using your cash flow.
Investing from your credit line is why the Smith Manoeuvre has a much higher benefit and risk than the Cash Dam. This investment risk is not high if you stick with the Smith Manoeuvre long-term and invest effectively and tax-efficiently.
To do the Cash Dam, you need to get a readvanceable mortgage linked with a credit line, so that you gain credit in the credit line with each mortgage payment. Then you need to setup how you will trace the flow of cash.
In practice, it can be tricky to accomplish. Many people that do the Cash Dam also do the Smith Manoeuvre, which has a far higher benefit from the long-term growth of the investments.
If you are doing both the Smith Manoeuvre and the Cash Dam, it is important to make sure that the Cash Dam does not end up with you having a smaller Smith Manoeuvre, because the smaller amount of investments can more than wipe out all the benefit of the Cash Dam.
The tricky part is that you pay down your mortgage to reborrow for 2 purposes – investment with the Smith Manoeuvre and paying your business or rental expenses. However, you only get the extra credit from your higher mortgage payments in one credit line. Which strategy will get the regular extra credit and which will not – your Smith Manoeuvre credit line or your Cash Dam credit line?
The solution is usually to have a separate unsecured credit line for the Cash Dam expenses for one year. Do the Smith Manoeuvre normally, but pay the cash from your business sales or gross rent onto your mortgage. You will build up extra credit in the Smith anoeuvre credit, but don’t invest it. At the end of the year, you split off a separate Cash Dam credit line to pay off the unsecured credit line.
You can then pay for another year of business or rental expenses from the unsecured credit line. At the end of year 2, you ask the bank to increase the limit on your Cash Dam credit line to pay off the unsecured credit line again.
This process is technical and takes some work, but is necessary to make sure you separate your Smith Manoeuvre credit line from your Cash Dam credit line. Both are tax-deductible, but on different lines on your tax return. If CRA audits you on either item, you need to be able to prove each deduction you claimed is correct.
It is most effective to do the Cash Dam as part of your long-term Financial Plan. You eventually convert your entire home mortgage into tax-deductible. Then what do you do?
The most effective strategy is usually to keep it forever as a tax-deduction and only pay it off whenever you sell your home. However, the Cash Dam credit line only is tax-deductible as long as you have that business or rental property. Keeping the credit line forever means you never have to use your personal cash flow for it.
If you will eventually retire and close your business or sell your rental property, but plan to retire in your home, then after your mortgage is fully tax-deductible for both strategies, you can do the Smith Manoeuvre on your Cash Dam credit line to slowly convert it all to tax-deductdible with the Smith Manoeuvre. You can keep the Smith Manoeuvre tax-deductible mortgage or credit line right through your retirement until you eventually sell your home.
You can also pay off your Cash Dam mortgage slowly, if you want to eliminate the debt, but this will mean you have to increase your payments to also pay off the principal of your tax-deductible mortgage over time.
Best Mortgage Strategy for Business Owners and Landlords
The Cash Dam is a pure tax strategy that gives you tax deductions just for setting up your mortgage and transactions in the right way. There is no investment risk. Your only risk is CRA audit risk if you don’t setup your separate credit lines and transaction tracing properly.
If you are already doing the Smith Manoeuvre, you already know most of how to do it. You can convert your mortgage to tax-deductible more quickly with both strategies at once, but make sure this does not mean you end up with a smaller Smith Manoeuvre.
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