Tax Managed Strategy 10
Not only can charitable donations provide individuals with the satisfaction of giving back to their communities, Canadian tax laws make sure that there has never been a more tax-advantaged time to give.
Donating to charities is a strong tradition in Canada, and something many of us find very appealing. Not only are we giving back to those less fortunate, but the government rewards us with a tax credit. If you currently donate or are thinking of donating in the future, you may be interested in this strategy.
Borrowing to invest can significantly increase your donation amount and tax savings
The charitable leverage strategy involves taking discretionary cash flow that you might otherwise use to fund an annual charitable donation and instead use those proceeds to pay the interest on money you’ve borrowed to invest.
The interest payments on the loan are generally tax deductible, and you can use these tax savings to pay the tax on any investment income earned in the year. Remaining amounts can then be donated to a charity. At the same time, you now have a large lump-sum amount invested that takes advantage of the benefits of compounding so that you can make a significant donation in the future.
Another alternative is to continue to make your annual charitable donations but use the resulting tax savings to fund an investment loan. The investment loan is used to purchase non-registered investments. The loan interest is generally tax deductible and is paid with the tax savings from your charitable donations. So, you now have the potential to significantly increase the value of your non-registered investment portfolio over the long term by having a large lump sum invested, which benefits from the effects of compounding and can also be used to make an additional sizeable future donation, if you so choose.
An in-depth look at the issues and opportunities
Normally, when transferring the ownership of publicly traded securities like stocks, bonds, mutual funds, and segregated fund contracts to charity, the donor would have to pay tax on 50% of the capital gains realized from the assets’ appreciation in value.
However, the Income Tax Act (Canada) allows for the donation of publicly traded securities to benefit from a capital gains inclusion rate that’s reduced to zero per cent. In other words, the tax on any capital gains from the disposition of publicly traded securities donated directly to a charity has been eliminated—a significant tax savings.1
With the charitable leverage strategy, the cash-flow requirements are the same as if you were making an annual contribution. However, in addition to increasing the amount of the donations and the tax savings, this strategy gives you the flexibility to:
- end the program at any time
- continue the program for as long as you like to maximize your donations and tax savings
- hold back annual donations if you need the money.
How borrowing to invest can work—case study
Joe would like to start making annual charitable donations. He has $3,000 of annual discretionary income eligible for contribution. Joe would like to maximize the amount of his charitable contribution and would like to accomplish this as tax efficiently as possible.
Here’s how Joe’s situation looks using this leverage strategy:2
Determining the amount of the loan
Joe’s annual donation amount will carry an interest-only loan of $60,000, calculated as follows:
How Joe’s situation stacks up
The $3,000 amount that Joe can afford to donate each year is now used to cover all borrowing expenses. The annual interest expense deduction provides Joe with tax savings that, minus any tax on the investment income, is donated to charity.
What it looks like at year 10
At the end of year 10, the value of the $60,000 invested is $47,451 (with the loan repaid), which, when combined with the donation of the annual tax savings, results in a total donation of $56,533.
As you can see, by using this charitable leverage strategy, Joe’s cash flow requirements haven’t changed but he has nearly doubled the amount of his donations over 10 years, from $30,000 to $56,533. This not only benefits the charity, but it also has increased his tax savings by $6,085—a win-win situation.
Here’s how it works, step-by-step
Apply for an investment loan and use the funds to purchase non-registered assets.
Loan interest is paid with the annual discretionary cash flow that you were otherwise going to donate.
Loan interest that’s paid becomes a deduction on your tax return.
Tax savings from the interest deduction, minus any tax on the investment income, is donated to a charity each year.
At the end of the desired time horizon, use the investment to repay the loan and donate the residual to charity.
As outlined above, it’s a simple strategy, and it can make a big difference to your bottom line.
Many Canadians’ 2020 tax return was unlike any other, depending on whether it was due to a change in employment status, business revenues, eligible tax deductions and credits, COVID-19 related benefits or any combination of the above. Let’s look at some of the changes, their impact and potential planning points, going forward.
As of April 29th, 2021, the Canada Revenue Agency (CRA) website noted that approximately 20.7 million Canadians had filed their tax return. Of those who have filed:
- 65 per cent will receive a refund, the average amount of which is $1,834,
- 24 per cent have a balance owing with the average amount due being $4,431,
- approximately 11 per cent had a nil balance.
How does this compare to last year? Of those who filed a 2019 tax return, approximately 70 per cent received a refund, the average amount of which was $1,832, and 18 per cent had a balance owing, on average, of $4,660. The remaining 12 per cent had a nil balance.
- Individuals currently donating to charity or planning to
- Individuals interested in giving back to their community
- Experienced investors with a long-term horizon and not averse to increased risk
It’s important to remember that this strategy may not be appropriate for someone with a low risk tolerance.
- Use the annual contribution amount to fund a leverage loan to maximize the donation amount and tax savings.
Investment options with Manulife Investment Management
Mutual funds can help meet your specific financial needs, throughout your life. Whether you‘re just starting out, accumulating wealth, or nearing/in retirement, Manulife Investment Management is committed to providing quality investment products and services so you can enjoy life and worry less.
Segregated fund contracts combine the growth potential offered by a broad range of investment funds with the unique wealth-protection features of an insurance contract. With Manulife Investment Management segregated fund contracts, investors can help minimize their exposure to risk through income, death, and maturity guarantees; potential creditor protection features; and estate-planning benefits—all from a single product or insurance contract.
Investment loans allow investors to make a large initial investment contribution and benefit from the potential for compound growth and interest deductibility. Manulife Bank loans are available for a variety of Manulife mutual fund accounts and segregated fund contracts, and offer attractive options such as 100% financing, no margin-calls on market fluctuations,3 interest-only payments, and a one-step application process.
1 This applies to direct donations to a charity (or donations in kind) while alive. If a direct donation occurs at death, a zero capital gains inclusion rate will only apply if the donation is a gift to which subsection 118.1(5.1) of the Income Tax Act (Canada) applies and that’s made by the taxpayer’s estate. 2 This illustration assumes that a specific percentage of loan interest is tax deductible. However, actual tax deductibility of loan interest depends on a few factors, with the Income Tax Act (Canada) providing the framework for determining deductibility. Tax laws are subject to change and, therefore, tax treatment of illustrated figures can’t be guaranteed. Results for Quebec residents may differ as the deductibility of investment expenses incurred by an individual or trust are limited to the amount of investment income earned during the year. Consult your tax and legal advisors with respect to your specific circumstances. 3 No margin-calls on 100% Loans and Multiplier Loans; however, if the loan-to-value (LTV) ratio exceeds 125%, then interest-only loans may be converted to a principal-plus-interest loan at the discretion of Manulife Bank. The no-margin-call feature isn’t available on custom loans. Borrowing to invest may be appropriate only for investors with higher risk tolerance. You should be fully aware of the risks and benefits associated with investment loans since losses and gains may be magnified. Preferred candidates are those willing to invest for the long term and not averse to increased risk. The value of your investment will vary and isn’t guaranteed; however, you must meet your loan and income tax obligations and repay the loan in full. Make sure you read the terms of your loan agreement and the investment details for important information. The dealer and advisor are responsible for determining the appropriateness of investments for their clients and informing them of the risks associated with borrowing to invest.
The commentary in this publication is for general information only and should not be considered investment or tax advice to any party. Individuals should seek the advice of professionals to ensure that any action taken with respect to this information is appropriate to their specific situation. Manulife Funds and Manulife Corporate Classes are managed by Manulife Investment Management Limited (formerly named Manulife Asset Management Limited). Manulife Investment Management is a trade name of Manulife Investment Management Limited. The dealer and advisor are responsible for determining the appropriateness of investments for their clients and informing them of the risks associated with borrowing to invest. The Manufacturers Life Insurance Company (Manulife) is the issuer of insurance contracts containing Manulife segregated funds and the guarantor of any guarantee provisions therein. Manulife Investment Management is a trade name of Manulife. Any amount that is allocated to a segregated fund is invested at the risk of the contractholder and may increase or decrease in value. Quick loans, Multiplier and Custom loans are offered by Manulife Bank of Canada. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the fund facts as well as the prospectus before investing. Mutual funds are not guaranteed, their values change frequently, and past performance may not be repeated. Manulife, Manulife Investment Management, the Stylized M Design, and Manulife Investment Management & Stylized M Design are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates under license.