Is Interest Paid on my Investments Deductible?
There is a proverbial expression that goes, “It takes money to make money”. When taken literally, this expression could be interpreted as the act of borrowing and using leverage to help increase income. Of course, this would also mean that a business or individual is increasing their risk in the pursuit of higher returns.
However, what is often overlooked in this endeavour is the room for effective tax planning and restructuring. Mainly, s.20(1)(c)(i) the Canadian Income Tax Act states that in computing a taxpayer’s income for the year, interest paid on borrowed money which is used for the purpose of earning income from a business or property can be deductible. This deductibility allows the individual or business to greatly increase their after-tax rate of return on their investment.
There are several criteria that must be met in order for interest expense to be deductible.
The Conditions of Interest Deductibility
First, it must be established that the money borrowed is used for the purpose of earning business or property income. Examples of property income include rent, dividends and royalties. Share appreciation through capital gains is not considered income. Therefore, if an individual or business purchased shares of a business, they must demonstrate that they expect to receive dividends.
Second, the interest on the borrowed money must be paid in the year or be payable during the year you are claiming the deduction. Lastly, you must be under a legal obligation to pay the interest and the interest expense amount must be reasonable.
It is also important to note that the Income Tax Act explicitly states that the interest expense deductibility is not intended for life insurance policies.
Interest Deductibility – An Example
One application of the interest expense deductibility for taxpayers is to deduct the mortgage on their house. More specifically, one can take out a home equity line of credit on their home and use those funds to invest in dividend yielding stocks or other investments. The interest rate on the home equity line of credit, which is often prime rate or a few points above, would be deductible when computing income.
Similarly, a taxpayer could restructure their borrowings in order to be eligible to deduct their interest expense. Consider the scenario where a taxpayer already owns 1000 shares of a corporation and a personal use condominium that was purchased through borrowed money. At this point, the mortgage paid on the condominium cannot be deducted as it was not borrowed for the purpose of earning income.
However, the taxpayer’s borrowing could be restructured and interest expense deductible if he/she does the following:
- Taxpayer decides to sell the 1000 shares of the Corporation and use that money to pay off the mortgage on the condominium; and
- Taxpayer now takes out a home equity line of credit or borrow money to re-purchase the 1000 shares of the Corporation.
By doing this, the taxpayer has now demonstrated that the new borrowed money was specifically for the purpose of earning income through purchasing shares of the corporation. As previously mentioned, the shares of the corporation must yield a return on capital and cannot be just capital gains. Examples of return on capital include but are not limited to dividend yielding stocks, mutual funds and Real Estate Investment Trusts.
Interest Deductibility – Tax Planning
If carefully planned and managed, individuals and businesses can use the interest expense deductibility provision of the Income Tax Act to greatly increase their after-tax returns on investment. With that in mind, the deductibility of interest continues to very contentious in tax courts and the meanings of “use”, “purpose of earning income” have been highly litigated.
If you need assistance with tax restructuring or have any inquiries regarding interest expenses, contact us today. Professionals at R&A Tax Law have years of experience developing effective tax strategies for both businesses and individuals.
This article provides information of a general nature only. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in this article. If you have specific legal questions you should consult a lawyer.