Some tax breaks we are better off without

A mortgage is a forced savings plan where the principal payments are socked away into a house whose equity will have grown by retirement. If you borrow on that equity, like author Fraser Smith suggests, you can even save on your taxes

A major difference between the United States and Canada is the tax deductibility of mortgage interest — Americans can, Canadians can’t.

While many Canadians lament their misfortune, it may actually work in our favour since the lack of a tax break is one more incentive to pay off a mortgage as quickly as possible, then focus on saving and investing. If you don’t accelerate the paydown of mortgage principal, interest charges can easily triple the effective cost of a home.

In the United States, by contrast, the existence of the tax break on mortgage interest makes the mortgage paydown option less compelling, which means American homeowners may well take decades to pay off their homes. Yes, they get the tax break but they also end up paying a ton of interest.

Rather than Canada imitating America’s policy, America might do better to copy Canada and end the tax break on mortgage interest, argues Fraser Smith, author of a book that explains how Canadian homeowners can make their mortgage interest tax deductible through a forced savings strategy that combines debt-paydown with reborrowing and investing.

The $mith Manoeuvre sold 53,000 copies and spawned a rival system by Smith protege Sandy Aitken. The latter’s Tax Deductible Mortgage Plan or TDMP helps mortgage brokers and financial advisors automate the procedure pioneered by Smith and adds some costs.

Either plan differs from the more cautious route of first paying off all debts, including the mortgage, and later focusing on building a retirement nest egg.

Smith says most Canadians don’t have enough time to take the “serial approach” of first tackling debt and later investments.

Without the continued forced saving and investing of his manoeuvre, he fears too many middle-class citizens will end up house-rich and cash-poor in retirement and be forced into the “abomination of the reverse mortgage.”

He says it makes more sense to tap home equity as it’s built up each month during the long years of paying down a mortgage.

As homeowners pay down mortgage debt, they borrow back a similar amount to invest, deducting the new interest expense from their taxes. Smith says this is not leveraging, but “converting” debt from “bad” non-deductible status to “good” tax-deductible status. (The real “leverage” occurred when the buyer took on a monster mortgage to buy a home in the first place: which all experience whether they try a “manoeuvre” or not.)

Early in 2009, in the depths of the financial crisis, Newsweek’s Fareed Zakaria noted Canada was shielded in part because of the absence of mortgage deductibility. While U.S. home prices fell 25%, Canada’s fell only half as much because “the Canadian tax code does not provide the massive incentive for overconsumption that the U.S. code does.”

Zakaria noted interest deductibility costs Uncle Sam US$100-billion a year, although the rate of home ownership is almost identical: 68% in the United States versus 68.4% in Canada.

Newsweek suggested President Barack Obama could learn from Canada, which inspired Smith to write a mock speech in which Obama announces the end of the mortgage interest tax break for Americans. You can find the full “speech” on my blog Wednesday at www.financialpost.com/wealthyboomer.Canada has never offered a mortgage interest tax break. Australia, Germany and Japan do not currently offer it either.

Smith (as Obama) says mortgage debt in the United States is more than US$10-trillion, generating US$1-trillion in tax refunds over the next 10 years (at US$100-billion a year) if the rule isn’t changed.

Smith/Obama argues US$10-trillion of mortgage debt converted to deductible interest investment loans would benefit the economy, taxpayers and retirement portfolios and take pressure off beleaguered Social Security.

The Canadian government likes the Smith Manoeuvre because it provides a “quid pro quo for all Canadian taxpayers, even those without mortgages,” Smith says. Those using the strategy receive tax deductions only if they use their cash to invest in new businesses and employment, thereby creating more “tax targets.”

Washington could do the same, phasing in the end of the tax “gift” over five to 20 years.

If Americans invested $1-trillion a year over a decade, Smith calculates that would grow to more than $10-trillion retirement assets, mitigating insolvent public and private pension systems.

jchevreau@nationalpost.com