March 7th, 2007

 

Blurb: Your parents always said save for a rainy day. Yet ironically in many cases, tax authorities treat borrowers better than savers.

 

The tax implications of borrowing and lending

 

By Peter Diekmeyer • Bankrate.com

 

With tax season now upon us, Canadian savers are en masse opening their mailboxes to find those dreaded T5 slips, which detail the interest they earned on their savings during 2006. On one hand, Canadian savers can be justly proud that they earned interest on money that was often the fruit of hard work and self denial.

 

Sadly though, unless those deposits are in tax sheltered RRSPs, the interest revenue is taxable at both the federal and provincial levels, often at exorbitantly high rates. Yet ironically, the interest that you pay when you borrow money is sometimes tax deductible. In fact the tax treatment of both saving and borrowing changes the entire calculus regarding whether it’s really worth it to save at all.

 

The bane of lenders: taxes and inflation

For individuals, you’d think that prudent long-term savings would be by far the best course of action. Didn’t our mothers always tell us to save for a rainy day? Furthermore you can even earn money on your savings. For example according to Bankrate’s rate guide:

(http://www.bankrate.com/can/rate/dep_avg_can.asp), five-year non redeemable GICs, which carry relatively low-risk, earn you roughly 3.65 percent. So your mother was right. Well she was…that is, until governments (both federal and provincial) got involved.

 

“You definitely lose out on most interest generating investments, when you take taxes and inflation into account,” says Evelyn Jacks, author of Essential Tax Facts and a slew of other tax-related books. Jacks believes that in most cases the tax treatment of borrowers, particularly those who borrow to earn income, is better than that accorded to lenders.

 

The problem is that if you are an average Joe, interest revenues are taxed and often at very high rates. For example, according to the Canada Revenue Agency’s rate chart:

(http://www.cra-arc.gc.ca/tax/individuals/faq/taxrates-e.html)

 a typical Canadian earning $40,000 a year in taxable income, pays 22 percent worth of federal tax on the interest revenues he earns, plus provincial tax, which in Ontario would work out to 9.15%. That means if you earned $1,000 worth of interest, you’d have only $686 left after you paid your taxes.

 

Put another way, that 3.65 percent worth of interest, turns out to yield just 2.5 percent, once taxes are worked into the equation. But taxes aren’t the only thing that savers have to worry about. Inflation, which has been generally running between two and three percent for several years now, eats up the rest of those interest revenues. The upshot is that after taxes and inflation, Canada’s savers have nothing left to show for their hard work and prudent financial management. In fact, during years when inflation is high, they often lose ground.

 

However for borrowers it’s a whole other story

Ironically, in many cases borrowers get a far better deal. For example take most Canadians’ biggest debt obligation: mortgages. Unlike our neighbors south of the border, the interest Canadians pay on their home mortgages is not tax deductible. In fact mortgage deductibility is a key reason that Canadians generally borrow far less than their American cousin.

 

That said, Canadian homes in most areas of the country have risen in value in almost all of the past thirty years. In recent years the gains have been particularly strong. During the past eight years the average existing home sold via the Canadian Real Estate Association’s Multiple Listing Service has almost doubled in value from $158,000 $300,000. And the more Canadians borrow, the bigger homes they can buy and the greater their capitals gains.

 

But here’s the crux, when a Canadian earns money on his deposits he pays tax on those earnings. But when he earns money through increases in his home’s value the capital gains are in most cases not subject to income tax. Of course there is no guarantee that house prices will continue to rise as fast as they have in the past. Yet the bottom line is that Canadians can legitimately borrow to buy bigger homes which they can leverage to earn tax free capital gains. It’s thus no wonder many Canadians choose to buy bigger homes rather than to save for the future.

 

Advantages increase when borrowing to earn other income

Canadians who borrow to earn income are in an even better position. That’s because any interest they pay on loans incurred to earn income is tax deductible. For example if you are running a small business and you borrow to buy a car, you can deduct the interest you pay from your total income at the end of the year.

 

If you borrow money to buy a business or stocks, you can deduct the interest that you pay from the income that those investments earn at the end of the year. In fact experts say that if you are thinking about taking out a mortgage on your house to open up a business, you’d be better off just taking out a business loan, because business loan interest is tax deductible, yet mortgage interest payments are not.

 

Of course none of this means that you shouldn’t save. That said, right now the tax structure clearly favors those who save though putting money into their homes, as opposed to those who put money into bonds or GICs. The one exception is Canadians who buy interest bearing instruments through their RRSPs. However they too eventually get hit when they take that money out.

 

Peter Diekmeyer (www.peterdiekmeyer.com) a freelance business and economics writer.

 

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