Deducting your Mortgage Interest
One of the best tax planning strategies available allows individuals to rearrange their affairs and receive an income tax deduction for mortgage interest or personal debt, such as a car loan. In order to implement this strategy, the individual must own some type of investment.
Background
The deduction for interest expense is straightforward. If funds are borrowed for business purposes or the purchase of investments, the interest is deductible. If money is borrowed for personal use, such as a car loan or mortgage, the interest expense is not deductible for income tax purposes. There are numerous exceptions to the general rule that interest borrowed for business or investment purposes is deductible and these include:
• no deduction is allowed for funds borrowed in invest in a RRSP, Registered Educational Savings Program or Tax Free Savings Accounts.
• funds borrowed to generate capital gains are not deductible, but if investment income were generated, the deductible would be allowed. Under the current legislation the tax department would be justified in disallowing an interest deduction related to a purchase of shares that never pay dividends. However, their current administrative policy allows a deduction, from the perspective that the shares may pay a dividend at some point in the future.
This guideline covers many borrowing situations, but the complexity results from tactics used by individuals that attempt to convert non-deductible interest to a tax deduction. Consider the following scenarios:
Scenario #1
An individual has $40,000 in a chequing account and is considering the purchase of a vehicle costing $40,000 or using the funds to purchase shares of IBM. After weighing the alternatives of a new “toy” vs. the investment, the individual decides to purchase both the automobile and the stock. Unfortunately, with only $40,000 of available cash, a loan is required. This provides a basic tax planning opportunity. If the cash is used to purchase the vehicle and funds are borrowed to purchase shares of IBM, the interest on the investment loan is deductible. If the individual used the available funds to purchase the stock and applies for a car loan, the interest on the loan would not be deductible.
This scenario provides individuals with a simple approach to attaining an interest deduction by attaching debt to investments, rather than personal assets. Unfortunately, individuals are seldom faced with the option of choosing between deductible and non-deductible debt options. Rather, many families possess assets financed by debt, such as a house and they may also own investments that have not purchased with debt financing. From a tax planning perspective, the family should attempt to transfer debt from personal assets to investment assets.
Scenario #2
• an individual owns a home that has a $50,000 mortgage
• he also owns $50,000 of stock and debt was not used to purchase the shares
• the stock is sold the proceeds used to pay off the mortgage. The individual borrows $50,000 and repurchases the stock
The result is the debt is attached to the investments and not the mortgage. Thus, the interest is now deductible for income tax purposes. This strategy is not always successful, especially if it is not properly documented. The tax department could attempt to apply the general anti-avoidance rule, which gives the government the power to set aside a transaction where there is no business purpose for the transaction, i.e., the transaction was undertaken for tax purposes and no other reason. To implement a tax planning strategy that maximizes your potential interest deduction, consider the following steps:
• consider using debt to finance investment purchases;
• all other factors being equal, pay off personal loans, before eliminating debt on investments loans; and
• if consideration is being given to transferring debt from personal assets to investments, ensure the documentation is perfect. Professional assistance may minimize the risk of a successful attack by the tax department
When considering such a strategy, consider the potential the capital gains implications if the asset sold will generate a profit.
