Two ways to deduct interest

Borrowing to invest doesn’t always lead to tax deductions.

For interest to actually be deductible, clients must take out loans that lead to the earning of income from a business or property (see “Watch out,” bottom of page, for ineligible uses).

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And there are other conditions:

• interest must be paid, or have accrued, in the year the client deducts it;
• there must be a legal obligation to pay back the loan; and
• the interest rate must be reasonable, based on market rates for debts with similar terms and credit risks.

A client needs to reasonably expect the borrowed funds will result in income, which can include interest, dividends, rents, royalties or business profits. Capital gains don’t count; they aren’t considered income. Canadian case law, further, has determined gross, not net, income is the relevant test.

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Here are two strategies that will make loan interest 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 clients’ tax returns and can be used to reduce income from any source, not just business or property income.

  Clients can’t use the loan money to pay personal or living expenses.

• Rearrange existing debts

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

  A client with an existing $200,000 mortgage and a $500,000 investment portfolio can sell enough securities to repay the mortgage. Then, the next day, she can borrow $200,000 to reinvest in the portfolio.

  When implementing this strategy:

  • sell off investments with low accrued gains, because any gains triggered are taxable; and
  • if investments are sold at a loss, wait 30 days to repurchase them. Otherwise, the CRA may deny these losses as superficial.

  Here’s another example. If your client has capital invested in a partnership with little or no debt against it, she can draw money out of it against her capital account. Then, she’d use the proceeds to buy or repay a mortgage, and borrow against the home to reinvest in the partnership.

Smith manouevre: The brainchild of Fraser Smith, this strategy can work for people who don’t have investments but do have equity in their home and a good revolving home line of credit. The homeowner borrows against home equity, invests that money in stocks, and uses the tax refunds from interest deductions to pay down the mortgage.

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A client’s line of credit limit increases by the exact amount of mortgage principal repayment, so he can immediately borrow back the principal and invest it. This process is repeated until the mortgage is paid off, leaving your client with a portfolio and a qualified investment loan.

Watch out

Be mindful of these points when deducting interest:

• You must be able to trace the direct use of money. Keep meticulous records and don’t combine borrowed funds with personal use funds.
• Be wary of investments designed to only produce capital gains—this may not be a qualifying use.
• 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.

Stella Gasparro, CPA, CA, a tax and assurance partner at MNP LLP.