Planning Opportunities with Leverage   by Peter F. Baigent CFP, CLU, CHFC, RFP.

Negotiating Debt For Your Client

Some of the leverage programs available to the advisor are highly structured and easy to use. However, I have found that better deals can be made with better terms for the client. We have made it a practice to submit the loan application ourselves on our own forms to a lending institution we have worked with for our clients, or to submit the application to the client’s bank, or both. I have found that lenders find the clients of a financial advisor to be their most desirable type of client. This is partly because an advisors client’s are high income, or high net worth, or at the very least responsible and determined to get ahead.

An obvious advantage to the advisor is additional fee revenue for this service, or the placement of the investments depending on the nature of the engagement with the client. However, the more important advantage is in protecting the client from over-zealous loan officers. Often the bank or other lending institution will want a higher rate of interest then will be warranted, or they try to make the loan appear that it is dependent on the customer bringing other business to the bank, or investing the borrowed funds with them. Tied selling is against the law but is seldom prosecuted by the regulators who fear doing their job and offending the big banks. As it is never good business to hold your assets at the same place that has your debt we can protect the client from that. If anyone thinks that a financial institution will not grab a client’s assets, registered, or not when they want to pay down their loan, just ask around.

Many lenders will want to treat an equity take out mortgage as a higher risk second mortgage, or they may try to have it CMHC insured at an added cost to the client. If the clients existing first mortgage and new second mortgage are in total less than the 75% of the appraised value of the home then fist mortgage rates apply and CMHC insurance is not required. This is an important negotiating point, which the client on their own is usually not up to arguing with the bank. As the advisor you can calculate an accurate loan to value ratio (LVR) and be the negotiator with the lender. In fact our loan proposal form shows the rate and terms we are looking for. So the lender knows before they even get back to us what we expect from them. After you have done a few deals with a lender and they have found your information to be credible, they quickly get to know what you expect if they want your referrals and the your client’s business.

In some cases we are also negotiating loans that are not secured by the client’s home. But the equity take out mortgage is our favourite because it does not require a personal guarantee and usually carries a much lower borrowing rate. Our work can be seen as financial advisor, debt consultant and then investment advisor. In either case, our fee is deductible to the client for this service in addition to any application fees, appraisal costs, etc. which they may be required to pay.

There is some truth to the old saying that: “A bank will only loan you money when you can prove that you don’t need it.” However an experienced advisor that believes leverage is right for their client can usually arrange for the funds. For the client that does not have a lot of assets for collateral, or room for very much debt servicing, a monthly saving program should be considered if debt re-financing is not workable. There are many programs on the market that will loan one dollar for every dollar invested thus starting a leverage program on a small scale, but almost doubling the clients’ investment potential. But read the fine print in the loan agreement. Keep in mind that the same potential for gain has a potential for loss as well. However, by investing for the long term that risk can be minimized.

Borrowing To Invest With No Tax Relief
Often debt can be used to meet other financial planning situations even if there is no tax relief. The obvious is of course debt consolidation, or the raw-land example mentioned earlier. However there are many other opportunities worth considering. One common example is a parent(s) who want to help their children but the children are not financially responsible enough, or they do not have any debt servicing room. Often parents are reluctant to give up capital for fear they may need it later in retirement. They may be sitting on a lot of equity in their portfolio or their homes, which they are not using. Taking a loan in their name and buying a portfolio of investments in their name in Joint Ownership with their adult child has some interesting uses. Firstly, junior cannot cash the investment without the parents blessing. In this case, at least half of the loan interest could be deductible. The estate can pay off the loan at death. The portfolio will pass automatically, without probate to the adult child at the parents’ death. The value of the portfolio can be deducted from the child’s share of the inheritance as per the will. The portfolio can even have the income paid to the adult child if the parents want to help out without giving up the capital. If junior is in bad shape financially, or he already has numerous loans, mortgages, or credit card balances, this can help while still protecting the parents. This arrangement need not be a part of the matrimonial assets if juniors’ marriage breaks up.

For the same reasons, the client can take a loan or a mortgage to help their favourite charity. In some cases servicing the loan is more attractive than using their own capital and may have immediate tax benefits. In cases where the clients’ do not want to use their own assets for fear of triggering a capital gain the loan route has some advantages. If the asset with a capital gain is a listed security it may now be advantageous to donate the listed security to the charity directly so as to benefit from the new 25% inclusion rate. If they do not want to realize any capital gains then a loan could be the answer. In a year of unusually high income, a sizable tax deduction can solve a lot of problems and help the charity at the same time. Paying off the loan from their eventual estate also reduces the net estate subject to probate fees.

Even using a life insurance policy as collateral for the loan entitles the borrower to a much lower interest rate at a bank, while freeing up capital for other purposes. But, mainly it can avoid any taxation resulting from borrowing directly form the insurer, or cashing out the policy and triggering an income inclusion for the year. Even though an old life insurance policy may have a low guaranteed loan interest rate, a large loan will usually produce a tax slip at the year-end for the amount borrowed in excess of the cost base. Many people are very surprised when they inquire as to the cash value of their old life insurance policies if they have also been reinvesting the dividends or using them to automatically buy paid up additional insurance. The problem is that many of these old policies have a cost base near zero. The loan cost may become deductible depending on what the funds are used for. But by using them as collateral they can use the funds for other purposes and leave the loan in place to be paid off from their estate with the tax-free proceeds from the life insurance policy.

For many years we have used second mortgages to help our children and client’s let the kids get into their first home. These are participating mortgages at zero percent interest drawn for the percentage the loan bears to the purchase price. So if the parents loan the kids 10% of the purchase price of the home, they receive 10% of the proceeds when it is sold. However, for the kids it allows them to get into a home sooner, does not affect their debt servicing ability, protects the capital in the event of a marriage breakdown and allows the parents to have a leveraged investment without any annual income to add to their tax until the property is sold. For another article on this subject: Click Here

Registered Retirement Savings Plans (RRSP) loans have been around for a long time and are popular in Canada with those people who can’t seem to get ahead and start on a Pre-Authorized Cheque (PAC) program. The rates are quite low and the loan can be paid off quickly if the client has the fortitude to apply the tax refund to the RRSP loan balance. I have always advocated one-year RRSP loans. But in some cases a client with a large unused contribution room can do some major debt refinancing by use of a large RRSP loan and perhaps a longer payback period if necessary. Some interesting scenarios can be developed to restructure non-deductible debt. A simple example is a client with 10,000 of credit card debt and 20,000 of contribution room who takes an RRSP loan for 20,000 in February. The tax refund at a 47% marginal rate would be $9,400.00 to be received within a few months. That plus the regular payments for a couple of months until the refund arrives should be sufficient to discharge the debt. Of course the client has to make payments on the RRSP loan for the year, but the interest cost on the debt is cut almost to a quarter of the credit card rate and within a year they are debt free. It also prepares the way for them to pay of future charge card balances each month.

Reverse mortgages are another example of non-deductible debt that can on occasion be the right answer for unique situations. We have used this in the past where a client does not want to downsize, but needs additional income

Although a client’s non-deductible debt is a financial planners worst nightmare, there are cases where it can be used to meet some of the client’s wishes.

Using Debt To Achieve Other Goals
Often the client is willing to undertake a leverage-investing program if it helps them reach another goal that may be more important to them. For instance many seniors find the Clawback of their Old Age Security (OAS) to be very upsetting to them. If after all of the other income sheltering methods have been used, the client will still be exposed to clawback, leverage can be very appealing to them. Interest paid to purchase investments is of course deductible the year it is paid. This reduces their net income and can put them back on the receiving end of the OAS. By lowering their income with the use of leverage they increase their eligibility for other government programs, which are income related, such as health care and home-care costs.

Income Splitting is probably the greatest benefit that can be achieved with debt. Where the client’s goal in the long term is income splitting, a leverage loan by the higher income earner with a low interest rate to the lower income spouse can help achieve the goal. It is important that interest at the prescribed rate, or a commercial loan rate at the time the loan is made, be paid with thirty days of the end of each year in order to avoid the attribution rules. A promissory note should be in writing to evidence the legal obligation to pay the interest. With the current low interest rate environment it is an ideal time to consider a loan to a lower income spouse, so as to lock in a low interest rate for a long period. In this case the loan paid by the spouse is a deductible expense to the lower income spouse. Even though the investments may be held in Joint Ownership for estate planning purposes it need not affect the interest deductibility if the loan and investment transactions are well documented.

An understanding of interspousal transfers and attribution rules may at first be intimidating. However, a little time spent understanding the rules reveals many planning opportunities. The CCRA Interpretation bulletin # IT-511R is 35 pages long and a perfect cure for insomnia. If you can get through it, you will find other ideas on how to help your client while staying within the spirit of the rules.

There are many variations for income splitting, both deductible and non-deductible, including reverse attribution. For children remember that capital gains do not attribute back to the parent. There is no attribution to parents on income reported by an adult child.

For new clients that come to you with prior unrealized losses the gain can be realized and the proceeds from the investment applied to any non-deductible debt. After thirty days the client can repurchase the investment if desired form funds acquired from new borrowing and thus have the cost of carrying the investment tax deductible. The realized loss can also be carried back up to three years to be applied against prior capital gains. Recent rulings by the Supreme Court of Canada have reinforced the rules about the deductibility of loan interest.

Summary
We have found that even the wealthy like to use leverage to invest even if they do not need to accumulate more assets. It is for some, just part of the game of wealth accumulation. For others it gets them to where they want to go faster. For the advisor it is a powerful tool to get the client to where they want to go. Everyone knows that any portfolio that can go up 20% or more in a year can also go down 20% or more in a year. The trouble of course is that the loan still needs to be repaid regardless of the value of the portfolio. Although leverage can be a high risk if not handled properly, arranging the debt properly can minimize the risk to the client. By starting small if necessary, the client can get comfortable with the process and still have funds elsewhere for use when needed. The larger the loan the more important it is to protect the client against margin calls, or calls on a demand loan. Choosing the correct investment mix for the portfolio is very important. Coordinating the proper terms of any borrowings is just as important a part of your fiduciary responsibility to the client. Used properly, leverage can be a great tool for you to help your client reach their goals.

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