DEBT SWAPS

Debt swaps entail replacing non-deductible debt with deductible debt. Let's look at an example to see how it works:

Jason has non-registered investments worth $50,000. He also has a house worth $400,000 and a $200,000 mortgage. He has an unused home equity line of credit (HELOC) secured by the house with available credit of $100,000. A debt swap consists of selling the non-registered investments, using the proceeds to pay down the non-deductible mortgage, and then borrowing the same amount using the line of credit and making new (or even the same) investments in a non-registered account. The line of credit interest is tax deductible because the loan proceeds are used to make an investment. The order of events is very important here – the loan proceeds must be used to make the investment. This strategy has been supported by court cases including the famous "Singleton Shuffle" and even more recently the Lipson case (the taxpayer lost but the judgement pretty much supported a straight forward debt swap). Please note however, that each person's circumstances are different and the above noted cases and situations may not apply to you. And if CRA disputes your tax deductions, you may incur legal costs and may have to present your case to the courts, and of course, you might lose. Poor execution of any tax reduction strategy always bears the risk of disallowance.

I have seen some blogs where the blogger stated that the loan interest would not be deductible if used to buy an investment where the return would be in the form of capital gains (because capital gains are not considered income). This would be true if the only potential return would be capital gains, but that is rarely the case. Let’s say for example that someone used borrowed money to buy a certain large well known software company's stock 10 years ago. At the time, the company was not paying a dividend, so at that point the only kind of return you could get was in the form of capital gains. But because there was still the potential to earn dividend income at some point in the future, the courts have ruled that the loan interest is still deductible. And as it happens, the company eventually started paying dividends, which just proves the point. The CRA recently issued a tax bulletin confirming this interpretation (IT-Bulletin 533).

Although a debt swap does not increase your overall risk (and one could argue that it decreases it slightly because your interest becomes tax deductible therefore your cash flow is improved), a more conservative option would be to simply liquidate the investment and pay down the debt. but be sure to see risk section below