Tips for deducting interest

Borrowing to invest doesn’t always lead to tax deductions but if done properly, it can.

For interest to be deductible, you must take out loans that lead to the earning of income from a business or property.

And there are other conditions. The interest must be paid, or have accrued, in the same year you deduct it, there must be a legal obligation to pay back the loan, and the interest rate must be reasonable.

The borrowed funds need to result in income, but capital gains don’t count; they aren’t considered income. And it’s the gross, not net, income that counts.

Here are two strategies to ensure your loan interest is deductible:

Borrow to earn

Take out a loan to buy income-producing assets (such as machinery for a business) or to earn business or property income (such as leasing business premises or buying a rental property).

At year-end, qualified interest is a deduction on your tax returns and can be used to reduce income from any source, not just business or property income.

Remember, you can’t use the loan money to pay personal or living expenses.

Rearrange your existing debts

Another strategy is the debt swap. Convert a non-deductible mortgage debt by paying off an existing mortgage, and re-borrowing to invest the proceeds.

For example, with a $200,000 mortgage and a $500,000 investment portfolio, you can sell enough securities to repay your mortgage then borrow $200,000 to put back in your portfolio.

Similarly, even with no investments, with good revolving credit you may be able to borrow against your home equity, invest that money in stocks, and then use the tax refunds from interest deductions to pay down your mortgage.

Your line of credit limit increases by the exact amount of mortgage principal repayment, letting you immediately borrow back the principal and invest it. This process is repeated until the mortgage is paid off. This example is a long-term plan that means servicing a large debt.

Whatever approach is best for you, remember:

• You must be able to trace the direct use of money. Keep clear records and never combine your borrowed funds with personal-use funds.
• Stay away from investments that only produce capital gains. Capital gains don’t count as income.
• Compound interest is not deductible unless paid in the year.
• If you lose part or all of your investment, you may still be able to deduct the interest.
• Selling eligible investments and spending the money for personal use makes loan interest ineligible.
• Interest to earn exempt income or acquire a life insurance policy is not deductible.