By Keith Vincent , NP LLP, Taxation Services
A number of years ago, Miss Take purchased her principal residence with help from her bank. A lot of hard work and countless mortgage payments later Miss Take is now mortgage-free. Miss Take now feels that the old house isn’t satisfying her needs anymore and she’s looking to move to a bigger and better home. The old home has increased substantially in value and Miss Take has developed a certain affinity for the place so she has decided to keep the house and rent it out.
Relying on her equity in the old house, back to the bank she heads to take out another mortgage on the old place to buy her new home. The mortgage interest paid on the old house will go a long way in sheltering from income tax the rent Miss Take receives. It should be smooth sailing ahead, or so she thinks.
Everything seems just fine until Miss Take pays a visit to her accountant to get her personal tax return completed. After reviewing the facts, the accountant has determined that Miss Take has fallen victim to the “big mistake” – what seemed like very logical steps to follow at the time have left Miss Take with taxable rental income but non-deductible mortgage interest – clearly not the most desirable outcome.
What do you mean non-deductible interest? She did borrow against the rental property after all, didn’t she?
The error in Miss Take’s game plan is her assumption that conversion of her former principal residence to a rental property and placing a mortgage on that same property to buy her new home will result in tax-deductible interest. Unfortunately for Miss Take, this is not the case. Although greatly simplifying the issue, provided the amount is reasonable, interest paid is generally deductible for income tax purposes under the following conditions:
- The interest was paid or payable in the year in accordance with a legal obligation, and
- The borrowed funds were used for the purpose of earning income from a business or property – the term “property” referring to interest income, dividends, rents and royalties but not capital gains.
The first condition rarely causes problems because most loans are properly supported by a written agreement but the same can’t be said for the second condition.
The Canada Revenue Agency has produced an Interpretation Bulletin, IT-533 Interest Deductibility and Related Issues, which provides its interpretations of the deductibility of interest expense under various provisions of the Income Tax Act and the judgments in numerous court decisions involving the deductibility of interest expense.
Please watch for next week’s issue for further information on the second condition and a solution to the mistake.