Ensure legal soundness when rearranging mortgages

It’s been just over eight months since the Supreme Court of Canada effectively blessed the plain vanilla debt swap strategy, often known as the “Singleton shuffle,” in the now- infamous Lipson decision, involving the General Anti-Avoidance Rule (GAAR).

Advisors will recall in the Lipson case, Earl and Jordanna Lipson wanted to buy a home. Jordanna borrowed $562,500 from the bank and used the money to purchase $562,500 worth of shares in the family’s corporation from her husband at fair market value. The tax rules allowed the shares to automatically roll over from Earl to Jordanna, and no capital gains were realized or reported.

Earl then used the $562,500 received from Jordanna to buy the home. A mortgage was then taken out on the home and the proceeds from that mortgage were used to replace the original investment loan.

While the Income Tax Actallows taxpayers to deduct interest expense on loans when the funds are borrowed for the purpose of earning income, the twist in this case was that the interest expense attributed back to Earl under the attribution rules.

The Supreme Court invoked the GAAR and ruled that the attribution rules were used favourably, essentially frustrating their purpose, and denied the interest expense.

Notwithstanding the fact that the Lipsons lost, rearranging your financial affairs in a tax-efficient manner to make the interest on investment loans tax-deductible by replacing non-deductible debt with tax-deductible debt, appears to be alive and well, absent a misuse of the attribution rules.

A tax case decided last month, however, reminds us it’s absolutely critical when rearranging your debt to do so in a legally correct and effective manner.

The case (Sherle v. The Queen, 2009 TCC 377) involved Nina Sherle who owned a rental property (Property A) with a mortgage on it, upon which the interest was deductible. She also owned a personal residence (Property B) free and clear.

Sherle wanted to switch properties; in other words, live in Property A as her personal residence and rent out Property B. When doing so, she stated she didn’t want to change her financing strategy, which was to live in her personal residence (soon-to-be Property A) mortgage-free.

To accomplish this, Sherle mortgaged Property B to pay off the loan on property A. As a result, she was now making interest payments on the new mortgage secured by Property B. She deducted this interest on her tax returns but was reassessed by the Canada Revenue Agency.

The CRA argued that for interest to be deductible, one must look to “the actual, direct use of the borrowed funds” and whether such use was for the purpose of earning income. Since in this case the mortgage proceeds were used to pay off the loan on Property A, which was to be a non-income producing property (her personal residence), the interest was not tax-deductible.

The Judge agreed and emphasized the jurisprudence on this point was clear. As the Judge wrote: “Why funds are borrowed is irrelevant … It is the use of the funds that governs… In the present case, the required link between the use of the proceeds and the income-producing property is just not there.”

In an ironic twist, the judge went on to describe what Sherle could have done to permit the interest to be deductible. While somewhat complex, it essentially involves Sherle selling Property B to a friend in return for a promissory note.

The next day, Sherle borrows money from the bank to pay off the mortgage on Property A. She then buys back Property B from her friend financing that purchase through a mortgage on Property B.

Her friend takes the proceeds from the sale of Property B and uses them to repay the promissory note. Finally, Sherle takes the proceeds from the promissory note to pay off the bank loan.

The end result is that only the mortgage on Property B is outstanding. The interest should be tax-deductible since the direct use of the mortgage proceeds was to buy the rental property.

Jamie Golombek,CA, CPA, CFP, CLU, TEP, is the managing director, tax & estate planning with CIBC Private Wealth Management in Toronto.Jamie.Golombek@cibc.com