Cash damming is a strategy to convert the interest on personal debt, which is not tax-deductible, to deductible interest on business debt, by using a line of credit to pay your business expenses. Individual business owners, rental property owners, self-employed workers, and sole proprietors can take advantage of cash damming.
The following description uses rental income as an example of how the cash-damming strategy works.
How Does Rental Cash Damming Work?
Real estate investors understand that the mortgage interest is tax-deductible when you borrow money to purchase a rental property. The same goes for any expenses related to carrying the property, such as maintenance costs, property taxes, condo fees, etc. By extension, the interest cost on any money borrowed to pay for these expenses is also tax-deductible.
Savvy real estate investors leverage this fact to optimize their cash flows for greater tax efficiency.
This is accomplished by using the rental income from their portfolio to pay down their primary residence mortgage and then borrowing the money to fund their monthly rental expenses.
This process is known as “debt conversion” and will generate increased tax refunds over time. Investors are advised to use the tax refunds to pay off their mortgage faster, thereby reducing long-term interest costs.
Cash Damming for Home-Based Business or Rental Property
When most small businesses start, part of the excitement is going to the bank to open a business account.
You order company chequebooks and deposit books.
The money starts to flow into your new bank account, and you pay the company bills at the end of the month.
If there is anything left, you write a cheque to yourself, call it a ‘draw,’ and deposit it to your personal chequing account… okay, fair enough – nobody uses ‘cheques’ anymore – but the principle is the same…
This is a fine and efficient setup if you don’t have a house mortgage. But if you have a mortgage (or other non-deductible debt), there is a much better way to structure your banking.
It is called the Cash Flow Dam, and it is extremely powerful.
Proprietorship Versus Corporation
Being able to implement the Cash Flow Dam relies on you owning a proprietorship.
A proprietorship is a business, but it is different from a corporation. A corporation is its own legal entity – you may own 100% of it, but the corporation itself is as real as you are in the eyes of the law and is as distinct from you as anyone else.
A proprietorship, however, is you. It is an unincorporated business you run and own as if it were yourself. In other words, any income from the company is treated like any income you receive in wages or salary from your job. And you can do anything you want with this income.
And a proprietorship is not necessarily just a rental property; it can be a home-based business you own, a hotdog cart, etc.
Cash Damming Rental Property
Say you own a proprietorship – a rental property – nothing too fancy, but a nice little place for which you have found good renters who pay on time every month and keep the house and garden tidy.
You receive $2,000 in rent each month from your tenants and promptly use it to make the mortgage payment on your rental property, which also happens to be $2,000 per month.
However, you, and likely thousands of other Canadians, have been making a costly mistake every month.
You receive monthly rental receipts and promptly redirect them to cover your investment property’s mortgage payment.
Money in, money out.
While this seems the right thing to do – after all, you have a mortgage on your rental and have promised your bank to make monthly payments on it – it’s not ideal. You are missing out on thousands and thousands of dollars of benefits.
Make Your Money Work More Than Once.
And so, if the rental income you receive from your business – your rental property, in this case – is yours to do with as you see fit, let’s make it sweat.
All these years, you should have been applying these rental receipts of $2,000 per month as a prepayment against the non-deductible mortgage of your principal residence – the mortgage on the house in which you live.
A monthly $2,000 prepayment of the mortgage?
You will see that non-deductible mortgage eliminated in record time. Extremely powerful.
But what about making the mortgage payments on the rental property, you ask?
If you have the appropriate financing on your principal residence, you can get back at that $2,000 to service the rental property mortgage.
You will have immediately converted $2,000 of non-deductible mortgage debt on your principal residence to deductible debt. Now you’ve generated a tax refund you otherwise would not have received (increased cash flow for yourself) while on your way to getting rid of that expensive mortgage in record time. The sooner you are rid of that mortgage, the less you will pay in interest. And less is better. Much better.
The Cash Flow Dam requires no new money and no new resources of any kind from you. The benefits are free and accrue as a result of reorganizing your finances, just like wealthy people do.
Cash Damming vs. The Smith Manoeuvre
The Smith Manoeuvre and the Cash Dam convert your typical mortgage into a tax-deductible mortgage over time, but the implementation and outcome of both strategies differ. The key to the cash-damming strategy is that interest paid on borrowed amounts used for business expenses is tax-deductible.
In contrast, The Smith Manoeuvre effectively makes interest on a residential mortgage tax-deductible in Canada. As a financial planning strategy, The Smith Manoeuvre involves converting the interest a homeowner pays on their mortgage into tax-deductible investment loan interest.