Do you know the difference between good debt and bad debt. In essence, good debt is debt that is debt that is used to purchase an asset that appreciates in value or has some income producing potential. Bad debt on the other hand is debt that is used for consumption like spending on cars, furniture, electronics, trips etc.
The term debt swap is basically the idea of turning bad debt into good debt. Most commonly, swapping debt takes non-deductible debt and turns it into tax deductible debt.
Converting to deductible debt
One of the best kinds of debt, if used properly is deductible debt. According to the CCRA, the interest on your loans are deductible if the debt is used for (1) the purpose of business and (2) for investing. Being able to deduct the interest makes the debt much more cost effective. Deductible debt gets cheaper if you have a higher marginal tax rate. A 7% loan only costs you 4.75% if deductible at a 32% marginal tax rate. The after tax cost drops to 4.2% if your marginal tax rate is 40%. When used wisely, deductible debt can actually be a smart financial strategy.
The best way to understand how debt swap works is to look at an example. Let's assume you have $15,000 line of credit that you used for personal consumption. Since the debt was used for personal consumption, the interest on the line of credit is not tax deductible. Let's further assume you have $15,000 invested in Canada Savings bonds, GICs, or mutual funds outside of the RRSP.
The first step to help you convert the debt to deductible debt is take the $15,000 investment and cash it in. Use the money to pay off the line of credit. Then, re-borrow off the line of credit to invest back into the same investments you once owned or invest it into a new portfolio of investments. Since you used the borrowed money to invest, you can now deduct the interest.
Keep in mind this example is over simplified. It ignores the effect of taxes and fees that can be triggered when selling the investment in the first place.
Tax loss selling
Speaking of taxes, one added bonus in this strategy happens if the investments sold have dropped in value. In that case, selling investment at a loss allows you to trigger a capital loss that can be used to offset capital gains now, back three years or saved for the future. Debt swapping allows you to re-evaluate your portfolio and assess whether you want to keep the losers or invest in something completely different.
Keep tax-deductible debt separate
Whenever you have debt that is tax deductible, be sure to keep that debt separate from non-deductible debt. Co-mingling non-deductible debt with deductible debt can create administrative nightmares in case you get audited.
Co-mingling also doesn't help when it comes time to pay down the debt. When you have both deductible debt and non-deductible debt, ideally you want to pay down the non-deductible debt first. When you pay down a loan where the use is co-mingled, you can't just pay off non-deductible debt first. If 75% of the debt is for investment and 25% is for personal use, then any repayment has to be applied in the same split.
The bottom line
Debt can be used to your advantage especially if the interest is deductible. The rules can be complicated and you should consult an accountant or a financial advisor when trying to create deductible debt. Always take the time to understand the risks of using leverage or deductible debt.
If this is all too complicated a simple version of debt swap is to convert high interest debt to low interest debt.