Ms.
Smith owned a principal residence and a rental property. She owned her
residence free and clear without any debt secured by the property. She had
taken out a mortgage to purchase the rental property and was able to deduct her
interest on that mortgage since the property earned rental income. That is, she
directly used the mortgage proceeds for the purpose of earning income, so the
taxman allowed the deduction for her interest costs. She then swapped the
properties so that her principal residence became a rental and her rental
became her principal residence.
Ms. Smith still wanted
to own her residence (the former rental) free and clear of debt, so she
borrowed funds against the new rental property (her former home) and used the
proceeds to pay off the debt on her new residence (the former rental). Follow
me? CRA then denied Ms. Smith her interest deduction going forward. They went
to court over the issue, and CRA won the battle in court.
The ideas I mentioned before that your intention or purpose for borrowing
money is irrelevant when it comes to deducting interest. Further, the assets
you pledge as security for the debt are also irrelevant. All that matters is
direct use of the borrowed money. So, what could Ms. Smith have done
differently to enable a deduction for her interest? More importantly, what can
you do today to ensure that you’re entitled to deduct interest on your debt?
Here are a few ideas:
1. Sale to a friend:
Ms. Smith could have
sold her principal residence to an accommodating party – say, a friend or
relative – in exchange for a promissory note. She could have then borrowed
money from the bank to repurchase that property from her friend or relative.
Her friend or relative could have then used the cash to repay the promissory
note owing to Ms. Smith. If Ms. Smith then used the property to earn rental
income (as she did), then she would have been able to deduct the interest on
the new debt.
2. Sale on the open market:
Suppose you have
non-deductible interest on some debt. If you have other cash or marketable
securities available, consider taking that cash or selling those securities for
cash, using the cash to pay down your non-deductible debt, and then borrowing
to invest in new assets (perhaps replace those same securities you just sold)
with a purpose of producing income. Presto, you should be able to deduct your
interest costs now. Just be sure to count the tax cost associated with selling
any marketable securities beforehand. If you don’t like the tax hit you’re
going to face when selling those securities, consider the next idea instead.
3. Transfer to a corporation:
Suppose you have
non-deductible interest on some debt and you have other assets, perhaps
marketable securities available. Consider transferring those assets to a
corporation (even if these assets have appreciated in value there should be no
tax to pay if you make an election under Section 85 of the Income Tax Act when
making the transfer; see a tax pro). In exchange, take back a promissory note
for the cost amount (that is, the adjusted cost base) of the assets transferred
(the promissory note cannot be for more than the cost of those assets,
otherwise you could trigger some tax). Then, borrow funds from the bank to
subscribe for more shares in your corporation. The corporation can use the new
cash to pay off all or part of the note owing to you. You can then use the cash
to pay down your non-deductible debt. You should now be able deduct the
interest on the new debt since the proceeds are used to invest in shares of
your company.
4. Take out paid-up capital:
Once again, suppose you
have non-deductible debt. Suppose you also own shares in a private corporation
and you have “paid up capital” in those shares (generally, you’ll have paid-up
capital in shares to the extent you have subscribed for those shares using
cash). Your corporation can then make a tax-free return of all or some of that
paid-up capital to you (see a tax pro for different ways to do this). You can
then use that cash to pay down your non-deductible debt. Finally, you can then
borrow funds to reinvest in more shares of the corporation, or to lend money to
the corporation (even at zero interest; CRA’s Interpretation Bulletin IT-533
confirms that interest will generally be deductible in this case).
Always be an informed client.
at 416-920-9931
