RRSP Self Mortgage: Non Arms Length Mortgages

What if you could be your own bank? Instead of forking over thousands of dollars in interest every year on your mortgage loan to one of the Big 6 banks (who earn billions in profits each year), you shovel that money straight into your RRSP. Month after month after month.

You can do this by setting up a non arms length mortgage in your RRSP. This whole scheme is actually new to me as well. I've long known of people who invest in arms length mortgages from their RRSPs. In fact, the secondary market for arms length mortgages is large and promoted quite aggressively in the inner circles of real estate agents and mortgage brokers.

But a week or two ago, a regular reader of this blog asked me to look into self-directed mortgages held within your own RRSP, better known by the banks and tax man as the self-directed RRSP non arms length mortgage.

There are important distinctions between an arms length mortgage investment in your RRSP and a non arms length mortgage in your RRSP, so I'll give a brief overview.

A transaction or contract with a party at arms length means you are dealing with someone who has no close connection to you. When you use your RRSP to provide a mortgage to someone at arms length with you, you can set the terms and rates at whatever you want. It is essentially a private loan secured by real estate. Typically this market is geared towards second and third mortgages and are higher risk. There are few restrictions involved and the loans are often managed by a third party who takes a hefty cut of the profits.

A non arms length mortgage is a loan to immediate family members and corporations where you are an influential shareholder, again secured by real estate. When this mortgage loan is made through your RRSP, there are a number of restrictions in place to protect your RRSP and prevent funny business.

This post will deal solely with non arms length mortgages through your RRSP. That is, you using your RRSP money to finance your own mortgage loan, or a mortgage loan to a child, parent, sibling, or similar close relations. I'll call it the RRSP self mortgage.

RRSP Self Mortgage

By law, RRSPs are not allowed to hold real estate directly. However, RRSPs are allowed to invest in mortgages. They can issue a loan to an individual or corporation which is secured by underlying real estate. This means, subject to a number of rules, you can actually use your RRSP to finance your own home purchase and completely cut out the banks.

To begin with, you must have enough money in your RRSP to finance the entire mortgage amount. It doesn't matter if this is a refinancing or a new home purchase. It also doesn't matter if it is a first mortgage or second mortgage on the property. However, the loan-to-value ratio cannot exceed 90%.

The home must be occupied by you as a primary home or vacation home. You can use a RRSP self mortgage to finance a multiple unit property up to four self-contained units provided you live in one of those units.

Also, you must have the regular downpayment amount, or existing home equity, from a source other than your RRSP self mortgage. This could be cash on hand, or money from a RRSP Home Buyers Plan if you are eligible. Just remember, using the RRSP Home Buyers Plan shrinks the amount of money remaining in your RRSP for the mortgage loan.

Your entire RRSP self mortgage must be administered by a third party trustee. This generally means the trust division of a handful of Canadian banks including Canadian Western Trust, TD Bank, CIBC (not confirmed), and B2B Trustco (not confirmed). Digging into this, I can tell you the documents and information regarding self mortgages are often buried in the fine print. The only provider which openly advertises non arms length mortgages through RRSPs is Canadian Western Trust. It is important to note that the trustee is obligated to act in the interest of your RRSP, not you.

Finally, your RRSP non arms length mortgage must be insured regardless of the loan-to-value ratio. This mortgage insurance follows standard rates and requirements and is provided by CMHC or Genworth Financial. Both providers accommodate insurance for RRSP self mortgages. Mortgage insurance is mandatory because the government doesn't want to have you in a situation where you default on your own mortgage and deplete your RRSP in doing so.

Fees and Set up Costs

Setting up a self mortgage with your RRSP is not a cheap process. First, you are required to obtain a professional appraisal of the value of your property which will cost a few hundred dollars. Then, you must pay set up fees to the trustee ranging from $200 to $500 depending on the trustee.

The mandatory mortgage insurance will likely add several thousand dollars to the set up costs. Even if your net worth greatly exceeds your loan value, your mortgage amount is a small percentage of your property value, and you could not possibly default, you cannot get around this.

Finally, for the duration of the mortgage you must pay annual fees to the trustee. Again, these ongoing fees vary significantly depending on the provider but in general range from around $100 to $300 per year.

Additional requests or actions made by the trustee on behalf of your RRSP are also subject to more fees. This includes mortgage renewals, discharges, payment confirmations, legal and other fees when processing arrears, and so on.

While the total cost of establishing a RRSP self mortgage depends on a few variables, it would be safe to expect the costs to be in the range of $1,000 to $5,000 in addition to the costs you would incur obtaining a standard mortgage from the bank.

Other Considerations

These non arms length mortgages are not restricted to a RRSP account. You may also use other registered accounts such as a RRIF, LIF, LIRA, Locked-in RSP, or RDSP. However, the account must be a self-directed account, not a group plan.

As a bonus, the loan amount is not considered a withdrawal, so it could be a particularly attractive prospect for someone who has a large LIRA or Locked-in RSP but is under the minimum age to get money out of their locked account.

RRSP self mortgages are not a way to get money out of your RRSP tax free and then default on your RRSP by not making payments. If you fail to make the required regular payments according to standard industry mortgage terms, the trustee will start a foreclosure process on you. Not only will you lose your house, you will be paying fees upon fees throughout the process. While you might become homeless, your RRSP will stay intact thanks to the thousands of dollars you paid for mandatory mortgage insurance.

During the foreclosure process is the only time your RRSP can technically hold real estate as an asset. However, your RRSP must sell the property within a year and, again, the sales process is completely in control of the trustee who is obligated to act in the best interest of your RRSP, not you. For example, you have no real control over the sales price and certainly can't set the price unreasonably high and live in your own foreclosed home forever. You may also be subject to hefty tax penalties if your RRSP holds the real estate for more than a year.

You must still meet all the standard mortgage qualifiers, just as if your were applying for a mortgage with a bank. This means an appropriate downpayment or equity in your home, the ability to make payments based on current qualifying mortgage rates (including the new B-20 rules), your TDS ratio must be lower than 44% of your income and GDS ratio lower than 39% of your income, you must provide income and employment verification, have good credit scores, etc. etc.

With a non arms length RRSP mortgage the interest rate you can set is restricted to certain parameters even though you are technically loaning money to yourself. The rate you pay, and qualify for, must be approximately equal to the posted rates of commercial mortgage lenders. However, you can choose your mortgage terms whether that is a 1 year open, 3 year variable rate, or 10 year fixed rate mortgage. It's up to you but must be consistent with commercial practices.

Try avoid setting up the mortgage with very short terms like 1 year open or 1 year closed mortgages. Most trustees charge a fee of a few hundred dollars every time you renew a mortgage term.

Subject to very specific situations, don't get fooled by paying your RRSP self mortgage the highest interest rates you can to maximize your RRSP value or "investment returns". If you do this, you are in fact robbing yourself to pay the tax man. How? Well, a big RRSP is not necessarily a good thing because you pay full income tax rates on the withdrawals down the road. Also, the mortgage payments you make to your RRSP are not considered RRSP contributions. It would be like contributing to your RRSP without getting the tax deduction that makes the RRSP so valuable when you earn a moderate to high income.

In most situations, you are technically better off to pay the lowest interest rate possible (usually a 5 year variable discount rate) and invest the excess monthly cash flow by properly contributing to your RRSP and getting the deduction, using your TFSA, or investing in your non-registered account as tax efficient as possible. This way your RRSP self mortgage can be a form of transfer from a high tax retirement savings vehicle to a low tax or no tax retirement savings vehicle.

Should You Get a RRSP Self Mortgage?

All this information begs the question: are self mortgages (non arms length) funded by your RRSP worthwhile?

I think it depends on your financial situation and your individual risk tolerance, so lets look at a few scenarios from best case to worst case.

An Investor with No Mortgage

A RRSP self mortgage could be a great solution for someone who has a large RRSP, is a savvy investor, has no mortgage currently, and wants to save a lot of money on tax. It is particularly suitable for a retiree or someone with low employment income.

In this scenario you could set up a RRSP self mortgage where the interest is 100% tax deductible. By borrowing against your home for investment or business purposes, you create a loan where the interest is tax deductible from your other income. There must be a clear trail for the money from your RRSP account to a non registered investment account or business.

As you make mortgage payments back to your RRSP account, the majority of those payments, especially at the beginning of a mortgage term, will consist of interest. Just a small part of the payment is principal. This could allow you to pull most of those payments back out of your RRSP effectively tax free.

If needed, you could refinance your mortgage again in the future to access more RRSP funds. However, you would need the cash available in your RRSP and the appropriate equity in your home.

This strategy is effectively an asset swap. You don't acquire any debt, you don't technically increase your overall assets. You simply invest outside of an RRSP rather than inside your RRSP, still using your RRSP money. It is a shift for tax savings purposes only.

I will go into more detail on this strategy in a future post as there is massive potential here to save tens or even hundreds of thousands in tax on your RRSP. It is basically a way, maybe the only legal way, of getting a serious amount of money out of your RRSP tax free or at very, very low tax rates so it deserves a thorough analysis and explanation.

The Big RRSP Retiree Who Is Mortgage Free

If you need money for a large purchase, lets say a vacation home or something similar, and all your assets are tied up in an RRSP, a RRSP self mortgage could be a good way to get that money largely tax free.

Normally, if you make a RRSP withdrawal, you pay full income taxes on that withdrawal. That means a large purchase financed by a RRSP withdrawal could cost you tens of thousands in taxes alone, requiring you to make a still bigger RRSP withdrawal to pay the tax bill.

For example, to get $300,000 in spending money from your RRSP, you would need to withdraw well over $500,000 in order to pay the tax bill. If the money you need is a big enough amount, it is almost certainly better to pay the costs of setting up a RRSP self mortgage and just take the $300,000 out tax free.

You will need to make larger RRSP withdrawals over time to pay your RRSP self mortgage payments, but it's better to withdraw an extra $15,000 every year to make those payments than it is to withdraw a few hundred thousand dollars in a single year and pay taxes at 50% rates or higher on that large withdrawal.

You could also be better off self financing your big withdrawal with an RRSP self mortgage rather than getting a HELOC or personal loan. Assuming your portfolio is in cautious investments, it is likely that your loan rate would be higher than your expected investment returns. If you are a retiree, you might not even be able to get a loan at a reasonable rate because you are not employed and deemed to be a higher risk by many lenders.

The Risk Averse Saver With A Current Mortgage

If you are an extremely risk averse saver who has a large RRSP account while maintaining a mortgage, then a RRSP self mortgage is a good choice. You will certainly do better than investing in a GIC or similarly safe investment asset.

Over 25 years, at today's rates, the interest on your mortgage can easily equal 50% or more of the value of the loan. If you have a $400,000 mortgage, expect to pay at least $200,000 in interest costs over the course of the mortgage loan. Any risk adverse saver would quickly see they would rather have that $200,000 in their own pockets than ship it off to the banks.

My hesitation with this scenario is the risk averse saver part. With a RRSP self mortgage, you are putting all your eggs into a single basket: your house. Instead, get a good fee-only financial advisor or learn about self-directed investing and set up a properly diversified investment portfolio. You don't need a lot of exposure to stocks to outperform mortgage rates over the long term.

An Investor with a Current Mortgage

If you are a true investor, someone who is willing to take risk, and you have a mortgage with a bank, I don't think RRSP self mortgages are a great choice in today's market.

Current mortgage rates are barely above the rate of inflation, so why not get all the money you can from your bank and invest as much as possible for higher returns? Also, obtaining a RRSP self mortgage for your own house and giving the bank the boot means you are not obtaining the mortgage for investment purposes. That means no tax deductions on the mortgage interest.

For an individual in this scenario, I believe the Smith Manoeuvre makes more sense financially. The Smith Manoeuvre allows you to deduct the interest of your investment loan (HELOC portion) from your income at tax time. Plus you invest at preferential tax rates in a non-registered investment account. In the meantime, your RRSP is invested at an expected long term return of 6% or more and you can worry about taxes on future RRSP withdrawals later.

Use a bank mortgage and the Smith Manoeuvre to maximize your productive assets, pay the bank their low interest rate, get the tax deduction, and invest for higher returns elsewhere through a well designed portfolio.

I also don't believe the bond substitute argument is a good one for someone in this case. Bonds have an important place in your portfolio to reduce volatility; we know they do not generate huge returns.

I think it would be short-sighted for someone to establish an RRSP self mortgage and invest their entire portfolio aggressively in stocks with the argument that the mortgage is their bonds. It works great until they see a 40% or larger drawdown in their all-stock portfolio. When that happens, I'm betting the "investment return" (payments) they are making towards their RRSP because of the self mortgage will hardly be a consideration. After all, they are only seeing their investment portfolio value shrink day after day.

If a 2007-08 repeats itself, they could see the value of their home shrink together with their portfolio. However, in those years bonds did quite well with their 10% annual returns, nicely offsetting some of the losses from the stock side of the portfolio.

Comments & Questions

This is an archived post and all comments are disabled for management efficiency. You can email me for direct questions.

Please visit my new website and blog for current posts on financial topics. DArends.com

TFSA or RRSP or Non-registered Investment Account

In Canada investors and savers have three primary accounts in which they can place money for retirement. All these accounts will allow you to invest in a wide range of financial securities. The most common securities include bonds, publicly traded stocks, mutual funds, ETFs, and publicly traded REITs both domestic and foreign listed.

The biggest difference between these accounts is how they impact your personal tax situation. Taxes, unfortunately, can become very complex even at the individual level. This unnecessary complexity is why all these special tax treatment accounts, like the RRSP and TFSA, have been created.

Read this post to get an understanding of investing and investment taxation across different accounts.

The complexity of these special accounts have given a distinct advantage to people who hire professionals to assist them with their finances (generally the wealthy crowd), or Canadians who have taken the time to understand the implications of each account on their wider tax and benefit situation.

Lets discuss the differences between these accounts and which accounts you should choose for your situation.

TFSA

Tax Free Savings Accounts are available to every Canadian over 18 years old. The annual contribution is capped at $5,500 (in 2018), but the contribution room amount is cumulative if you don't put money in your TFSA. You contribute to a TFSA with after-tax money, but you don't pay any taxes on withdrawals. Any investment returns made within the account, including dividends and realized capital gains, are not taxed.

Under the current system, you don't even need to report withdrawals from your TFSA account on your income tax forms. This means, if all your income is from a TFSA, you could appear to have ZERO income and maximize your benefits in retirement--including benefits designed for very low income seniors such as the Guaranteed Income Supplement (GIS).

RRSP/RRIF

Registered Retirement Savings Plan is a tax-deferral account available to every Canadian who files taxes. The annual contribution limit is equal to 18% of your earned income up to a maximum contribution increase of $26,230 (in 2018); unused RRSP room is cumulative and can be carried forward. You get a tax refund for RRSP contributions at your highest marginal tax rate, but you must pay full income taxes on withdrawals from RRSP accounts. Realized income kept within the RRSP account are not subject to tax until withdrawals are made.

Once RRSPs are converted to a RRIF (Registered Retirement Income Fund), any withdrawals you make are eligible for the Pension Income tax benefits and can be split with your spouse. RRSPs must be converted to a RRIF when you turn 71. RRIFs have mandatory withdrawals which are based on your age and the value of the account. The minimum withdrawal rate increases as you get older. You may not make any contributions to a RRIF account.

You can make withdrawals from a RRSP account when you are working, but the withdrawals will be added to your other income and be taxed at full tax rates. However, you can "borrow" money tax-free from your RRSP using the Lifelong Learning Plan (LLP) or Home Buyers Plan (HBP). You are required to "pay back" your RRSP when using these special plans. If you don't make those payments, the minimum required repayment for that year is added to your income and taxed as if it were a RRSP withdrawal.

Non-registered Investment Accounts

These are standard investment accounts which receive no special tax sheltering or deferral treatment. There are no limits on how much money you can contribute to a non-registered investment account, which makes them the default choice once contributions to registered accounts have been maxed.

Taxes on certain types of investment income--Canadian dividends and capital gains--are lower than taxes on employment income. You must pay taxes on any gains you realized during each tax year which reduces your net investment returns. Due to the lower realized investment returns after taxes, registered accounts (RRSP/TFSA) are often preferable to non-registered accounts. You can make your non-registered accounts more tax efficient by investing in products that do not generate income and where capital gains can be deferred for long periods of time. Swap-based index ETFs are a good example of this.

Low Income Comparison ($40,000)

Source: TheRichMoose.com

When you are in a lower income situation, you will find minimal differences between the accounts. From a pure income tax view, the RRSP with reinvestment of the tax refund is the best choice, just slightly beating out the TFSA. That's because you would slightly benefit from the difference between the highest tax rate on contributions and a lower blended tax rate on withdrawals. This small difference is mostly due to the basic personal deduction. Non-registered accounts do quite well for low income individuals because the tax rates on realized gains within the account along the way do not significantly impact returns and can actually reduce your overall tax bill in certain situations.

Middle Income Comparison ($70,000)

Source: TheRichMoose.com

If you are in a middle income situation, you will find the RRSP account with reinvestment of the tax refund to begin pulling away from the other options. The spread between tax refunds on the RRSP contribution and taxes owing on the RRSP withdrawals to increase. Even with relatively careful investing, the actual return on investments after taxes in the non-registered account will begin to suffer more.

High Income Comparison ($120,000)

Source: TheRichMoose.com

If you are a higher income individual, RRSP accounts should be your first priority. The spread in tax refunds on RRSP contributions and taxes owing on RRSP withdrawals continues to grow. Also, you must be very careful how you manage any investments in your non-registered investment accounts because the taxes on realized income there get quite punitive! Again, the TFSA is always a reasonable option that performs well.

It's Not This Simple

If you take a quick look at these charts, you might assume it is always best to invest in your RRSP first--as long as you reinvest your tax refund. While the RRSP is certainly a decent choice regardless of your income, the way our system of tax credits and other social benefits are designed makes it much more complex.

The real answer of the best account for you depends not just on your gross income, but also on your spending and total savings rates. For example, a reasonable person earning $120,000 should be saving much more than $5,500. You should save at least 10% of your gross income if you start young, expect a reasonable retirement, and will have a paid-off house by the time you retire in addition to your investments.

An individual saving $12,000 per year returning 6% over a forty-year period will see their account grow to nearly $2 million. You can't invest $12,000 per year in a TFSA, so you will be forced to save in your RRSP from that perspective. However, if your RRSP is worth $2 million at retirement, your tax rate on $80,000 of RRSP withdrawals will be quite high (22.09%). You will also get benefit clawbacks at this level of income.

RRSP accounts are also less flexible than TFSA or non-registered accounts. When you turn 71, your RRSP must be converted to a RRIF and you must make mandatory withdrawals from the account at a rate that climbs higher every year--even if you don't need the money. Since RRSP withdrawals are taxed similar to employment income, they are more difficult to access during your working years as well.

When RRSPs Should Be Prioritized

Although there are numerous complexities involved and it's never very straightforward, you should consider making the RRSP your first priority if you:

  • Are more educated in financial planning and are serious about reducing income taxes
  • Will always invest the tax refund back into your RRSP
  • Have a moderate to very-high income when you are working (over $50,000)
  • Don't spend a lot of money relative to your income
  • Plan to retire early so you can reduce your RRSP before it must become a RRIF
  • Have a very small amount of money to contribute and want to maximize your total investment value
  • Make sure your RRSP account doesn't get too big so you can keep your withdrawals to a minimum
  • Invest in a more active style, often realizing gains
  • Will not make any withdrawals for any reason while you are working
  • Might use advanced strategies to reduce taxes on withdrawals (borrow to invest strategies)
  • Will go back to pursue full-time education as an adult
  • Are buying a house in the future after not owning a home for four years
  • Plan to take a sabbatical or otherwise reduce your income substantially before retirement
  • Have an uneven income with very high years and low years (self-employed in resource sector)

When TFSAs Should Be Prioritized

TFSA accounts are newer, but they offer many advantages that RRSPs don't. You should consider making the TFSA the first account to invest in if you:

  • Value maximum flexibility in investments, contributions, and withdrawals
  • Want a tax efficient option that performs well in all income and spending situations
  • Believe you might make withdrawals while you are working for any reason
  • Are likely to spend as much, or more money in retirement than when you are working
  • Think your retirement will include large, but in-frequent expenses (travel, new vehicles, etc.)
  • Anticipate moving from a low tax province while working to a high tax province in retirement
  • Are already contributing to a pension plan that will pay a large benefit in retirement
  • Would like to maximize government benefits as a senior (OAS, GIS, Pharmacare, etc.)
  • Invest in a more active style, often realizing gains

When Non-registered Accounts Should Be Prioritized

In general, non-registered accounts are the account of last resort. This means you have contributed everything you can to RRSP and TFSA accounts. However, there are some exceptions and you should invest in a non-registered account first if you:

  • Have a rapidly rising income and will transfer to a RRSP later to maximize your tax refund
  • Invest in a Canadian dividend strategy, have a low income, and live in a low-tax province
  • Are low income and borrow money from a high income spouse (spousal loan)
  • Borrowed to invest in a tax-efficient way and use the interest expense to offset other income
  • Borrowed to invest so that you can maximize your net worth
  • Want to access a wider range of investments without restrictions
  • Are a very active investor who might be considered a "trading business" by the CRA

Mixing Account Contributions

Particularly for higher income individuals with high savings rates, the best strategy is likely to spread contributions across several accounts. Start with aggressive contributions to your RRSP to get large tax refund. Then you will use the refund money and any other savings to maximize your TFSA account contributions. Finally, whatever is left will go into a non-registered investment account. This is the strategy I employ.

I am targeting a sizeable, but not enormous RRSP account. A target valuation of somewhere around $1 million is probably as high as I want to go. This means I will either stop contributing to my RRSP, or significantly reduce contributions to my RRSP as I reach this value. If I can keep RRSP withdrawals under $40,000 a year per person and top up the rest of my income with TFSA withdrawals or dividends from my non-registered account I will be happy. I will also use interest costs to reduce my taxable income from RRSP withdrawals.

Summary

In Canada the typical saver and investor can save for the future in three different account types: the TFSA, RRSP, and Non-registered investment account. The TFSA and RRSP exist to provide savers with distinct tax advantages. TFSA are "tax-free" after your contribution; RRSPs are actually a tax-deferral mechanism, but you save on taxes by getting tax refunds at a high marginal tax rate but pay taxes on withdrawals at a lower blended tax rate after tax credits and deductions.

While TFSA contributions are not tax-deductible, you can invest in your account without being taxed on investment income and you can withdraw money from your TFSA without paying tax on your withdrawal or even claiming it on your income tax return.

You deduct RRSP contributions from your income, so you get a tax refund which should always be invested. You don't pay taxes on any investment income within your RRSP account until you make a withdrawal. RRSP withdrawals are taxed like regular income and you must report withdrawals on your income tax return. When you are retired, you would normally convert your RRSP to a RRIF so withdrawals can be treated as Pension Income for tax purposes. RRSP accounts are more intricate, not very flexible, but offer several embedded programs for earlier withdrawals. RRSPs are the ultimate account for tax arbitrage if you have a good understanding of the tax system.

Non-registered accounts are normally used after you have already contributed the maximum amounts to your RRSP and TFSA. Investment income from this account is taxed, but at preferential rates for Canadian dividends and capital gains on profitable trades. Non-registered accounts might be used first by individuals who are highly active traders, borrow money to invest, or are waiting until they are higher income before moving their investments to a RRSP. High income individuals should avoid realizing investment income in non-registered accounts.

Generally speaking, the RRSP can be the best account for investing even if you are lower income due to tax arbitrage. However, they are somewhat restrictive and require a reasonably good understanding of income taxes and Canada's social benefit system to get the maximum benefit. The average person is probably best off investing in a TFSA because the flexibility is unparalleled and it performs well in nearly all scenarios.

Side Note: I'm on vacation, so my posts next week will be put up a few days late.

Comments & Questions

This is an archived post and all comments are disabled for management efficiency. You can email me for direct questions.

Please visit my new website and blog for current posts on financial topics. DArends.com