Cash Damming Strategy Explained: Turn Personal Debt Into Deductible Interest
- Elkhanagry Accounting
- 7 hours ago
- 6 min read
Table of Contents
Introduction to Cash Damming
Cash damming is a strategy used by business owners and rental property owners to replace non-deductible personal debt (most commonly a principal-residence mortgage) with potentially deductible borrowing connected to a business or rental activity.
It does not make your mortgage interest deductible. Instead, it changes which expenses are funded with borrowed money and where your cash flow goes. Done properly, the interest you create may qualify for a deduction under ITA 20(1)(c), but only if you can prove the borrowed funds were used for an eligible income-earning purpose and your tracing is clean.
Even if you’re confident the concept works, deductions can still be challenged under the general limitations, especially the requirement that expenses be incurred to earn income under ITA 18(1)(a) and that amounts be reasonable under ITA section 67.
Benefits of Cash Damming and who can use it
Cash damming is typically a fit when you have (a) meaningful personal non-deductible debt and (b) steady income from a business or property with ongoing expenses.
In practice, the best candidates are:
Sole proprietors who have recurring operating expenses and predictable receipts.
Rental property owners who have recurring rental expenses and stable rent.
The main benefit is improving the “quality” of your interest cost by shifting some of it from personal, non-deductible interest to potentially deductible interest on a separate line of credit used only for business or rental expenses. Your personal mortgage interest doesn’t magically become deductible. Instead, how you fund ongoing income-related expenses, so that over time a larger portion of the interest you’re paying is connected to your income activity.
The second benefit is faster debt repayment overall, assuming your cash flow stays the same. When part of your interest becomes deductible, you effectively reduce your after-tax cost of borrowing, which creates tax savings (or a smaller tax bill). All else being equal, that means you keep more cash, and if you apply that extra cash to your personal debt, you can pay down the combined debt balance faster than you would under the normal approach, even if the total borrowing looks similar early on.
How to Structure Cash Damming Properly
A properly structured cash damming plan is built around one idea: you must be able to trace to an income-earning use that fits within ITA 20(1)(c).
That’s the core lesson from Bronfman Trust v. The Queen: the trust borrowed so it could make distributions to beneficiaries without selling investments, but the Supreme Court focused on the direct use of the borrowed funds (the distributions) and denied the interest deduction—even though, economically, borrowing helped the trust keep income-producing investments. The takeaway: courts don’t reward “overall balance sheet” logic if the direct use isn’t clearly income-related. If your expenses are irregular, your banking is mixed, or your line of credit is used for both business/rental and personal spending, the trail becomes blurry, making the interest deduction much harder to justify and defend if CRA reviews it.
On the flip side, Singleton v. Canada (SCC) shows how powerful clean tracing can be when the steps are executed properly. Mr. Singleton withdrew capital from his partnership to buy a home, then immediately borrowed the same amount and used the borrowed funds to refill his partnership capital account. The Supreme Court allowed the interest deduction because the direct use of the borrowed money was tied to an income-earning source (his partnership), even though the overall series was connected to a personal home purchase. The takeaway for cash damming is practical: structure and sequencing matter, and mixing personal spending into the borrowing facility destroys the direct link you need to defend the deduction.
The clean, defensible structure
A strong structure usually has three moving parts:
A dedicated LOC used only for eligible business or rental outlays. This LOC should be used exclusively to pay expenses that are clearly tied to earning income. The moment personal spending hits the LOC, you introduce apportionment, contaminate tracing, and weaken the deduction position.
Separate deposit flow for business or rental receipts. Your business/rental income deposits go into a dedicated account. From there, you redirect surplus cash toward paying down your personal mortgage (directly or via transfer). The goal is to avoid “muddy water” where it’s unclear whether you used borrowed funds for business expenses or personal purposes.
Documentation designed for an audit file, not for convenience. For every LOC advance, you should be able to produce an invoice/receipt and show the payment from the LOC to that specific expense. CRA’s own administrative guidance on interest deductibility stresses the importance of being able to support the legal obligation and reasonableness of interest, and, in practice, that support starts with clean, traceable records.
Real-Life Examples of Cash Damming
Line item | Without cash damming (expenses paid from revenue) | With cash damming (expenses funded by LOC) |
Business revenue | 100,000 | 100,000 |
Operating expenses (tax-deductible) | (50,000) | (50,000) |
LOC interest (tax-deductible if 20(1)(c) conditions met) | 0 | (3,000)* |
Taxable business income | 50,000 | 47,000 |
Estimated tax on business income (assuming the top marginal Rate is 50%) | (25,000) | (23,500) |
After 6 Years: Estimated tax | (25,000) | (16,000) |
*Assuming a LOC rate of 6%
The Smith Manoeuvre: Cash Damming’s “Investment” Cousin
Cash damming and the Smith Manoeuvre are similar in one core way: they both use cash-flow routing and strict account separation to improve the “tax quality” of interest over time.
Where cash damming focuses on business or rental operating expenses, the Smith Manoeuvre focuses on investing. Instead of borrowing to pay income-related expenses, you typically use a re-advanceable mortgage/HELOC: as you pay down your mortgage principal, you re-borrow that same available limit and invest it in income-producing assets (often a diversified portfolio). You would then be able to deduct this interest from the returns made through these investments.
The biggest practical difference is the type of income activity being supported. Cash damming is usually tied to day-to-day costs in an active business or rental property (repairs, supplies, insurance, utilities). The Smith Manoeuvre is tied to building an investment portfolio, which introduces market volatility and behavioural risk that doesn’t exist in the same way when you’re simply funding expenses you already have.
Documentation and segregation matter in both, but the Smith Manoeuvre usually demands even tighter investment-specific tracking: proof of each investment purchase, statements showing the borrowed funds went directly to investing, and ensuring distributions/returns don’t accidentally blur the trail. In both strategies, the fastest way to create problems is mixing personal spending into the borrowing facility.
CRA References and Case Studies
CRA Income Tax Folio S3-F6-C1 (Interest Deductibility) — CRA’s main guidance outlining how interest becomes deductible, emphasizing the importance of direct use, proper tracing, and fund segregation. It also recognizes “cash damming” as a valid method when structured correctly.
CRA Technical Interpretation 2006-0218241E5 — CRA confirms that using a separate borrowing facility for income-earning expenses (“cash damming”) can support the deductibility of interest, provided the tracing remains clean and well-documented.
Bronfman Trust v. The Queen (SCC) — Denied the deduction because borrowed funds were not used directly for income-earning purposes, establishing the foundational “direct use” rule.
Singleton v. Canada (SCC) — Allowed the deduction where the taxpayer borrowed funds and used them directly in an income-earning partnership, reinforcing that proper sequencing and tracing can make or break a claim.
Ludco Enterprises Ltd. v. Canada (SCC) — Clarified that as long as one main purpose of borrowing is to earn income, interest may be deductible even if returns are low.
Lipson v. Canada (SCC) — Demonstrated that even technically compliant interest deductions can be denied under the General Anti-Avoidance Rule (GAAR) when structured primarily for tax advantage rather than genuine income-earning intent. GAAR can target a specific step, using the whole series for context. Even if each individual step “works” mechanically, the Court may look at the overall series to decide whether one step results in misuse/abuse of a provision’s purpose.
Income Tax Act paragraph 20(1)(c)
Contact Us!
If you’re considering cash damming, the planning question isn’t “Is this real?”—CRA has acknowledged it as a tracing-focused approach when it’s set up properly. The real question is whether your specific structure can support the interest deduction and hold up under review. Most problems don’t come from the idea itself—they come from messy tracing, mixed personal and business use, inconsistent cash flow, or weak documentation that makes the story hard to prove.
If you want an audit-ready setup, we can help you confirm whether you’re a good fit, design clean banking and borrowing flows, and build a simple monthly tracking process that keeps the paper trail tight and the interest position defensible.
Disclaimer
This article provides general information that is current as of the posting date and is not updated, which means it may become outdated. The content is not intended to provide accounting, tax, or financial advice and should not be relied upon as such. Tax and financial situations are unique to each individual and may differ from the examples discussed in this article. For personalized advice, please consult a qualified tax professional.
