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A strategy for dealing with debt in tough times

The Lovin' Spoonful sang it years ago: Did you ever have to make up your mind? Some decisions in life can be tough. Just ask my friend, Glenn, who shared with me that he was perplexed about two decisions this week.

Glenn's first decision had to do with his neighbour. You see, Glenn's dog, Oakley, has a bad habit of bringing things home. In the past, Oakley has come home with a neighbour's bike pump, canoe paddle, BBQ cover, and more.

Glenn's new neighbour, a woman who lives two doors down, just moved in and doesn't know about Oakley's antics.

This week, Oakley visited her yard, attacked the clothes line, and brought back to Glenn some red lingerie that, quite honestly, very few men should be allowed to look at.

It was decision time. Glenn figured he had four options: (1) Bury the lingerie in his back yard; (2) give the lingerie to his mother as a birthday gift; (3) wear it, or (4) take the lingerie back and apologize. I'm not sure he's made a decision yet.

Glenn's other decision was just as perplexing.

He's been concerned about his investments, and has been wondering what he can possibly do, if anything, to help himself financially at a time when markets are down. "Glenn, I've got just the thing for you," I said.
Your debt

This idea has to do with converting your bad debt into good debt.

"But isn't all debt bad?" you might ask.

No. To believe that is to assume that all debt is alike. You see, there are three key characteristics of debt that you need to look at: (1) the interest rate on the debt (high interest or low); (2) the purpose of the borrowing (for personal consumption, to acquire depreciating assets, or appreciating assets); and (3) whether the interest is deductible for tax purposes.

Take your credit card debt as an example. It's generally the worst kind of debt. Why? Because the interest costs are high (often 19 per cent or more), we typically use credit cards for personal consumption or to buy depreciable assets, and the interest costs are not usually deductible.

Now, what about your home mortgage? It's a better type of debt because the interest costs are much lower, and you're buying an asset that you likely expect to appreciate in value over time. You can't usually deduct your mortgage interest (unless your home is used in your work), so you lose out on this front.

Finally, consider a third type of debt: Money borrowed to invest. In this case, your interest costs are lower, you're buying assets that should appreciate in value over the long term, and the interest costs are generally deductible. This type of debt is arguably the best type of debt.
The debt swap

Here's the strategy: Consider selling some of your non-registered investments that have dropped in value (I'm guessing you've got some), use the cash proceeds to pay down some of your bad debt (credit cards, a line of credit or even your mortgage), then take out a new loan to replace those investments you've liquidated. By doing this, your total debt load will remain the same, but unlike the old debt you've paid down, the interest costs on the new debt should be deductible since you're borrowing to invest.
The benefits

The benefits of this strategy are clear.
1. You'll trigger some capital losses that, to the extent they can't be applied against capital gains this year, can be carried back to 1999, 2000 or 2001, to recover taxes paid, or can be carried forward indefinitely to save tax in the future.
2. You'll manage to swap bad debt for good debt by making some interest costs tax deductible, creating tax savings.
3. You'll have the opportunity to reconsider where you're investing your money and to buy at a time when, let's face it, many securities are on sale.

Forget about holding on to what you currently own until it has gone back up in value to what you paid, if there are better opportunities available.

Do you think the market knows how much you paid for your investments, and cares? As an aside, let me put in a good word for active money management here.

If it's true that equity markets are going to provide mediocre returns over the next decade, then index funds and exchange-traded funds (ETFs), while inexpensive, may become the most expensive investments you own as a result. Active managers who focus on the best businesses, in growth industries, and buy at cheap prices, should be able to beat the markets and offer value to investors. Some food for thought as you reinvest.
Tim Cestnick, CA, CFP, TEP is author of Winning the Tax Game 2002 and Winning the Estate Planning Game. He is managing director, Tax Smart Services, at AIC Ltd.
tcestnick@aic.com



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