Undo interest deductibility mistakes

If your client wants to borrow to invest, you’ve likely told her the good news: she can probably deduct the interest on the loan. You’ve also warned her the investment could fail to return enough to repay the loan. And if she’s considering a mortgage, you’ve told her she could lose her house if things go south. But have you also explained she could make at least part of the loan interest non-deductible with just one transaction?

Here’s why. CRA permits clients to deduct interest costs of an investment loan as long as it meets three conditions:

• It’s required to be paid or payable in that tax year;
• It’s a reasonable amount; and
• The borrowed money was used for “accepted purposes”—i.e., to earn income from a business or property. The direct use matters.

The third condition tends to be most difficult to meet because the moment loan money’s used for anything other than earning income, the interest on that portion is no longer deductible. Here are three common ways clients may taint their loans (and how to handle it if they do).

Scenario 1

What your client did: Amrita’s decided to buy a new home, but wants to keep her current, mortgage-free home to rent out. She re-mortgages her paid-off home to buy her new home, and thinks she can deduct the interest because the old home’s now an investment property.

She’s wrong. The mortgage proceeds are going toward her new principal residence, not her rental property, and “what’s relevant is the direct use of the borrowed funds,” says Keith Vincent, an accountant with MNP in Surrey, B.C. “Just because your mortgage is secured by your rental property doesn’t mean the interest is going to be deductible for tax purposes.”

How to fix it: Amrita should have borrowed funds to pay for the rental property—her first home. But she wants to unlock its equity. To do that, Amrita can set up a holding company and sell the rental property to it in exchange for a promissory note, at fair market value. That way, the holding company doesn’t actually pay any cash out.

Since Amrita had lived in the home until she decided to turn it into a rental, “gains on that property when it’s sold to the corporation will likely be sheltered by the principal residence exemption,” says Vincent.

The next day, she’ll borrow to buy back her rental home from her holding company. That way, Amrita is using the proceeds to purchase the investment property (her rental home) instead of her principal residence, and she’ll be able to deduct the interest paid on that mortgage.

The holding company will use the funds Amrita gives it to buy back the rental property to repay the promissory note (the one issued when Amrita sold the rental property to it in the first place).

Then, Amrita will use the promissory note repayment (not the loan proceeds) to buy her new home, which is her principal residence.

Warnings:

• Amrita needs to document all legal transfers in case CRA audits her.
• She could have early repayment penalties on the loan she takes out to buy back the rental home from her holding company.
• If Amrita couldn’t shelter the sale of her first home with the principal residence exemption, she could transfer it to a corporation using the Section 85 rollover to defer gains, says Vincent (for a detailed explanation, see advisor.ca/section85).
• She should check if the cost of setting up a holding company, as well as of the ongoing filing burden, is offset by the interest deductibility. (Fortunately, there are other tax benefits of owning a holding company, such as income splitting.)
• The land transfer tax may apply when Amrita sells her first home to the holding company, and again when she buys it back. “In B.C., the land transfer tax is 1% of the first $200,000 of value, and 2% on the rest,” says Vincent. To avoid paying the tax, in B.C., “we can transfer beneficial interest, not title.” So in this case, Amrita would hold the legal title in trust for the purchaser; a legal document could say something like, “Amrita agrees to hold the title to 123 5th Avenue in trust for Amrita Ltd. I will do whatever the company requests with respect to that title. Any funds that come in for that property are for the benefit of the company, and not me personally.” A lawyer can provide precise wording.
• In Ontario, “land transfer tax would be charged, [because] legal and beneficial ownership is acknowledged for transfer purposes,” says Glenn Willis, regional leader of MNP’s real estate and construction practice in Toronto. B.C. and Quebec are the only provinces that allow transfer of beneficial interest without the title having to change hands.
• It may be more tax-advantageous to hold an investment property in a holding company. Amrita should ask her accountant.

Scenario 2

What your client did: Three years ago, Karol borrowed $50,000 on a line of credit to buy some dividend-paying RazBerry stock, and has been legally deducting the interest on the loan. He hasn’t repaid any of the loan.

RazBerry has since dropped 40%, and he wants out. He sells all shares and gets back $30,000. To soothe his disappointment, Karol puts the $30,000 back on the line of credit and then uses that amount to buy a new car. Problem is, that’s a non-eligible use of the loan money because it’s no longer tied to the investment. The interest on the whole loan, including the $20,000 loss, is no longer deductible—he’s tainted it.

How to fix it: Rosa Iuliano, an accountant with Collins Barrow in Ottawa, says if Karol wanted to undo his mistake, he’d have to repay the entire loan, re- borrow the money and then use it for investment purposes. But Karol would need to scrounge up another $50,000.

If Karol hadn’t bought the car and instead reinvested the $30,000, he could have continued to deduct interest on the whole loan, even though RazBerry had lost $20,000, says Iuliano.

Warnings:

• It’s possible to taint the loan at any time, regardless of whether a stock has tanked. So “it’s important that any borrowing for investment always stays segregated,” says Iuliano. She suggests getting separate lines of credit for investment and personal use.
• CRA requires “an expectation of income” when borrowing to invest for loan interest to be deductible. Capital gains are not considered income in this context. So if RazBerry had never paid dividends, and no one expected it to, most likely deducting the loan interest would be offside.
• If Karol had tainted the loan before the losses occurred, he’d also have to sell the stock, pay back the debt and re-borrow the money to buy back the stock. If there were a gain, he’d have to compare his capital gains tax to the amount of the interest deduction to see where he’d come out ahead. “For a $50,000 loan at 3%, that’s a $1,500 deduction per year,” says Iuliano. He’d also have to consider how long he’s keeping the loan. (If he had losses to offset the gain, that may swing things in favour of reborrowing.) He’d also have to beware of the superficial loss rules.

Scenario 3

What your client did: David borrowed $10,000 to invest in a mutual fund that pays return of capital (ROC). He’s not sure whether the money he’s getting back is investment return or ROC. But he wants to replace his patio furniture, so he spends $500 of the mutual fund proceeds to do so. Turns out, the $500 was ROC, and he’s used the investment loan money for an ineligible purpose. That means he can no longer deduct interest on $500 of the loan.

How to fix it: If David had reinvested the $500 in income-producing property, interest on the entire $10,000 loan would still be deductible, says Lynne Zulian, principal, Tax Services at Grant Thornton LLP in Barrie, Ont. And if he’d used the $500 to repay the loan, the interest on the remaining $9,500 would still be deductible (and he would no longer be paying interest on $500 of the loan).

But since David bought patio furniture, he “used some of the loan for non-investment purposes. Then you have to go through a proration of the original loan,” she says. Now, only the interest on $9,500 is deductible.

It’s difficult to fix this mistake. You’d have to re-borrow $500 and invest those funds in order to once again be able to deduct interest. “You’d have $10,500 outstanding with the bank, but only interest on the $10,000 would be deductible,” she says. And he’ll incur transaction costs, so it may not be worth the trouble.

In future, David should look for the ROC amount in Box 42 of his T3 slips, or in fund company statements. “But some trusts don’t make that determination until after the end of the year,” says Zulian. “[During the year,] we don’t know what portion the client received is ROC.” To avoid problems, keep ROC distributions in the original investment account.

Warnings:

• If you let ROC sit in cash, “[while] I haven’t seen CRA attack that,” Zulian says, “it could say there’s no reasonable expectation of return,” and disallow the interest deduction. To be safe, clients could ask brokers to put all distributions in money market funds or high-interest savings accounts if they aren’t reinvested in the original fund.
• If interest rates exceed the investment return, interest is still deductible. But clients should consider if it’s worth selling the investment to repay the loan, and weigh the capital gains tax as well.
• In a falling-rate environment, you’re allowed to refinance a loan as long as you’re still using the proceeds for investing, says Zulian. That’s because “you’ve only touched the borrowing side.” But keep in mind, clients can only deduct the lower interest rate.

Melissa Shin

Melissa is the editorial director of Advisor.ca and leads Newcom Media Inc.’s group of financial publications. She has been with the team since 2011 and been recognized by PMAC and CFA Society Toronto for her reporting. Reach her at mshin@newcom.ca. You may also call or text 416-847-8038 to provide a confidential tip.