Cash damming for rental and business income

It applies to anyone whose spending is already partly deductible-purpose: an owner of one rental unit or of ten, a sole proprietor, a partner in a firm, an incorporated professional who pays some costs personally. What it needs is not capital. It is expenses you were going to pay anyway, and a second account to pay them from — which is why it sits beside the other ways of borrowing to invest in Canada as the one with no market exposure attached to it.

That also makes it the more urgent of the two. The conversion cannot be applied to a year that has already been paid for out of one account: what is not separated as it happens is separated afterwards by estimate, or not at all.

How cash damming works, in four moves

1. Open a line of credit for this and nothing else. A second facility, or a sub-account on an existing one, with a zero balance and no personal history behind it.
2. Pay every deductible-purpose expense from that line — the property taxes, the repair, the insurance, the supplier invoice — on the day it is incurred, rather than from the account your own money sits in.
3. Send the cash those expenses would have consumed against the mortgage as a prepayment. The money is the same money; the account it lands in is what changes.
4. Pay the line’s interest monthly from cash, and claim it as a carrying charge under paragraph 20(1)(c) of the Income Tax Act. Interest on money borrowed to earn income from a business or property qualifies; interest on the mortgage against your own home does not.

Repeat it monthly. The mortgage falls faster than its schedule, the line rises to roughly the total of the expenses it has paid, and the household’s total debt is close to where it would have been — held in a facility whose interest is claimable rather than one whose interest is not.

The account flow, and where it actually breaks

Each of the three is ordinary, and none of them announces itself. The consequence of the first is the one most often underestimated: it does not put the single charge at risk, it puts the balance at risk, because from that day forward each payment against the line reduces two purposes at once and the deductible portion has to be tracked as a proportion rather than as a list.

Contamination is what happens when borrowed money that was tracked to an income-producing use becomes mixed with personal funds or personal spending. The borrowed dollars can no longer be traced to the use that made their interest deductible, so the deduction is at risk for the contaminated portion of the balance.

What is usually happening instead

The objection this page meets most often is that the accountant already handles it. Usually they do — and the work generally happens once a year, after the fact. The statements arrive in the spring, a deductible share of a mixed account is worked out from twelve months of transactions, and that allocation goes on the return.

That is a reconstruction, and reconstruction is where tracing gets hard.

The direct-use test is the Canadian rule that decides whether interest qualifies for deduction: what matters is the use the borrowed money was actually put to, not the security pledged or the account it passed through. The Supreme Court applied it in Singleton v. Canada and in Ludco Enterprises v. Canada.

The test asks what a particular borrowed dollar was used for. It does not ask what proportion of a year’s spending was business-shaped. When every deductible-purpose expense left a dedicated line on the day it was incurred, that question has a documentary answer on any date you pick; when one account paid for everything and the split was computed in April, the answer is an estimate, however careful the person who produced it. The difference costs nothing while nobody asks. It is the whole difference when somebody does — which is the same year-end problem from the accountant’s side of the desk.

What the conversion is worth

For a $400,000 mortgage at 4.50% with 22 years of amortization remaining, $3,000 a month of deductible-purpose expenses routed through a 6.45% line of credit, and a 43.41% marginal rate, the mortgage is retired in 7.3 years instead of 22. The line of credit peaks at $261,000 — that is the non-deductible debt converted into deductible debt — and pays $197,339 of deductible interest, returning $85,665 in refunds. All debt — mortgage and line of credit — is gone in 21.3 years. Net interest to debt-freedom is $180,673 with the dam against $228,419 without it, a difference of $47,746. The level mortgage payment is $2,380 a month.

The spread between the two rates is what decides it, and it can decide against you: a line priced well above the mortgage it is replacing can cost more in interest than the claim returns. The cash damming calculator runs both lives of the debt — with the dam and without it — to full debt-freedom on your own balance, rate and spread, and prints a negative number when the dam loses rather than rounding that case away.

Where it goes wrong, and who it does not suit

• No deductible-purpose spending. An employee without rental or business income has nothing to route. The technique has no version for someone whose expenses are all personal.
• Expenses too small to matter. The conversion runs at the rate the expenses are incurred. A few hundred dollars a month against a large mortgage converts slowly enough that the paperwork outweighs it.
• A wide rate spread. See above: the arithmetic can go the other way, and the calculator will say so.
• One account for everything. If the dedicated line will in practice pay for the occasional personal thing, the split it creates is worse than the mixed account it replaced, because it looks separated.
• Nobody keeping the record. Every draw needs the same six facts that the record behind a claim sets out for its own strategy: what was paid, from which account, on what date, evidenced by what, and what later changed the answer.

A spreadsheet projects this well. What it cannot do is hold the evidence — which is what ACRU records, transaction by transaction, as the transactions happen rather than each spring.

Cash damming or the Smith Manoeuvre

They are not alternatives for most people; they are gated on different things. One needs business or rental expenses, the other needs a readvanceable mortgage and the appetite to invest with borrowed money. Plenty of households qualify for both and run both, and the arithmetic compounds when they do. Both strategies, side by side sets out what each converts, what each costs, and which one your income actually allows.