As a real estate investor looking for opportunities to diversify your passive income stream, the question of investing in private mortgages has likely crossed your mind. Much has been written about these non-institutional mortgage investments and their merit as part of your real estate portfolio.
As a necessary disclaimer, I have to agree with the conventional wisdom that private mortgages are a high-risk investment and should only be considered if the funds available for investment are surplus. Why? Because of the very real possibility that you could lose every penny.
But the silver lining to that towering cloud of doubt is that the higher the amount of risk involved, the higher the interest rate earned. Investors who use mortgage brokers experienced in making smart investment decisions – employing sharp underwriting techniques, using lower loan-to-value ratios and skilled at identifying lower-risk opportunities – have been able to secure stable and steady income in their investment portfolios by investing in private mortgages.
Thanks to recent tax changes affecting passive investment corporations, return on investment in private mortgages has been noticeably reduced. If you’ve teamed up with a qualified mortgage broker who is skilled at selecting suitable investments, or if you’ve located a private mortgage investment corporation that you’re comfortable with, consider using funds from your RRSP or TFSA to both boost your private mortgage investment power and reduce the tax impacts.
Select institutions, such as Olympia Trust Company and Canadian Western Trust Company, offer the ability to use your RRSP or TFSA funds in a self-directed mortgage investment. Naturally, these companies do not assume any liability or responsibility for the investment choice, but having access to some tax-sheltered funds means that the interest you gain is either tax-free or taxdeferred. Both are powerful ways to increase the value of your returns.
If you use a TFSA to fund a mortgage investment, the borrower’s principal and interest payments are automatically debited each month from their account back to your TFSA. The interest growth is tax-free and can either be drawn to fund your ongoing needs or reinvested to compound growth.
If you use an RRSP to fund a mortgage investment, the payments are also automatically debited from the borrower’s bank account back to your RRSP. The interest growth is tax-deferred and remains in your RRSP until you withdraw it in the future. Once the funds are drawn, taxes are payable to the CRA based on the amount drawn and other income sources in the pertinent year, so don’t forget to account for the tax man when you’re running your numbers.
Self-directed mortgage investments using TFSA or RRSP capital can be used to fund mortgages up to 100% of the value of the property – although that’s not a move most mortgage or legal professionals would recommend. In addition, these investments continue to give you the ability to exercise a profound amount of control, allowing you to choose:
- The property for the investment
- The borrowers
- The interest rate
- The term
- Additional provisions such as pre-payment charges, admin fees, etc.
The fine print
An added benefit is an extra set of trained eyes on the priority of the mortgage and the legal review of the title search. For example, to fund the investment, most institutions will require a copy of the parcel register pages of the title search to review for prior mortgages and notices, and to ensure that the mortgage is indeed a first-, second- or third-ranking mortgage (based on the investor’s direction).
Furthermore, upon registration, most institutions will require another copy of the parcel register pages to confirm actual registration and that the priority expected (first, second or third mortgage) is in fact fulfilled. The institution also confirms that prior encumbrances that were to be discharged at closing are in fact discharged.
Again, it’s crucial to keep in mind that the institution will not take liability for the investment. As the investor, you’re fully responsible for making the most critical decisions concerning the mortgage, the borrower and the loan terms. You’re also fully responsible for mortgage enforcement action if and when required.
Private mortgage investments are not for every investor. However, if you have the risk tolerance and the know-how, using a TFSA or RRSP to fund a mortgage investment can provide valuable tax reduction and access to a pool of funds.
Harpreet Hans is a partner with Gunding & Hans LLP in Milton, Ontario. She practices exclusively and extensively in the area of real estate law and mortgages.
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