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Borrowing to Invest – When Is Interest Tax- Deductible?

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Borrowing to Invest – When Is Interest Tax- Deductible? NavigatorThe RBC Wealth Management Services The Perry Shak Group RBC Dominion Securities Borrowing to invest – www.perryshak.com When is interest tax- deductible? As part of your overall financial plan, you may have borrowed money in order to invest. One attraction of borrowing to invest is the ability to deduct your Perry Shak, CFA interest expense for tax purposes. This deductibility allows you to increase Vice-President, Portfolio Manager your after-tax rate of return on your investment. However, it is important [email protected] to note that using borrowed money to finance the purchase of securities 514-840-7105 involves greater risk than a purchase using cash resources only. Should you borrow money to purchase securities, your responsibility to repay the loan as required by its terms remains the same even if the value of the securities purchased declines. The purpose of this article is to provide information with respect to commonly asked interest deductibility questions. Please contact us The information in this article is not intended to provide legal or tax advice. To for more information ensure that your own circumstances have been properly considered and that action is taken based on the latest information available, you should obtain about the topics professional advice from a qualified tax advisor before acting on any of the Rdiscussedaluca Popesc inu this information in this article. Asarticle.sociate Wealth Advisor [email protected] When is interest tax-deductible? 2. You must pay the interest 514-840-7104 When you borrow money, there are during the year in which you are four requirements that must be met claiming the deduction. Note that in order for the interest expense to be compound interest (interest on tax-deductible: your interest) is only deductible in the year it is actually paid. 1. The money you borrowed must be used for the purpose of 3. There must be a legal obligation earning income from a business pay the interest. The lender must or property. Business income be able to seek legal recourse includes any activity you carry against you in the event you do not Crystal De Fazio on for profit or with a reasonable make the interest payments. Administrative Assistant expectation of profit. Employment 4. The interest rate charged must be [email protected] income is not considered business reasonable. The Canada Revenue 514-840-7356 income. Property income includes Agency (CRA) has indicated that interest income, dividends, rents, a reasonable interest rate would and royalties. 2 | RBC Wealth Management be one that is established by receive dividends. Recent court cases prevailing market rates for debts have proved the importance of being with similar terms and credit risks. able to clearly demonstrate an income- earning purpose even on an ordinary How much can you deduct? acquisition of common shares. In provinces and territories (with the exception of Quebec, discussed The courts may also pay particular below), you need only to establish interest to the company’s history of When you dispose an intention to generate income. paying dividends. There have been of all or a portion of Actually generating income from the cases in which, considering all the your investments, you business or property is not necessary. circumstances, interest deductibility was denied because there had been will need to identify In addition, the amount of income you earn (or expect to be earned) no history of paying dividends on the the current use of company’s shares. All the more so, borrowed money to does not need to exceed the interest you pay in order to deduct it. For if a company expressly declares its determine the extent to example, if you borrowed money at intentions not to pay any dividends, which interest remains 8% to invest in something that earns or the class of shares does not allow deductible. 5%, the CRA will allow you to deduct for dividends to be paid, then the the full 8%, unless the transaction is a interest incurred on borrowed money sham. In other words, you must have would not be deductible. real and true intentions of earning Return of capital income from the investment in order to deduct the full amount of interest. There are certain types of investments Before undertaking such a strategy, that could make return of capital consider the effect it will have on your (ROC) distributions to you. These cash flow. include, but are not limited to certain mutual funds, Real Estate Investment If you live in Quebec, the provincial tax Trusts, Limited Partnerships, and laws limit the interest you may deduct Mortgage-Backed Securities. Since in any given year to the investment these investments have the potential income you earn in that year. Unused to pay income, interest paid on interest expenses can be carried borrowed money used to invest back three years and carried forward in these funds is generally tax- indefinitely to be deducted against deductible. However, how you use investment income in other years. your ROC distribution will impact the deductibility of interest each year. Types of investment income Consider the following example: Capital gains Suppose you borrowed $10,000 at It is important to note that capital 4% interest and invested it in mutual gains are not considered to be fund units. In the first year, you income for tax purposes, so interest incurred an interest expense of $400 resulting from borrowing to generate on the borrowed money and received capital gains alone will not be distributions of $1,400 in cash from deductible. For example, interest on the mutual fund. The distribution money borrowed to purchase a piece occurred at the end of the year and of art as an investment, would likely the distribution breakdown was not be deductible. “other income” of $500 shown on a Common shares T3 slip and ROC of $900. You then used the entire distribution of $1,400 If you borrow money to purchase for personal use. Is the entire interest common shares, the interest expense expense of $400 ($10,000 x 4%) will generally be deductible if there is deductible for tax purposes? a reasonable expectation, at the time the shares were acquired, that you will In determining whether your interest RBC Wealth Management | 3 expense is deductible for that year, the entire original borrowed amount, An example you need to look at what you are the full amount of the interest Suppose you borrowed $100,000 in currently using the borrowed funds expense should be deductible. order to acquire 100,000 mutual fund for (rather than the initial use of the units for an original cost of $1 per funds). For the first year, your entire Paying down debt unit. Let’s also assume that interest interest expense of $400 is deductible If you dispose of a portion of your on your borrowings is deductible for for tax purposes since for that year investments and decide to pay tax purposes. A few years later, the you invested the borrowed money in down your investment loan with mutual fund units have increased in mutual fund units. The capital was the proceeds from the sale, then the value to $120,000 ($1.20 per unit) so only returned to you at the end of the interest expense on the remaining you decide to dispose of a portion of year. For the second year, only the portion of the loan will generally the units, say 16,667 units in order to portion of the borrowed money that continue to be deductible. In the realize some accrued capital gains. related to your remaining investment case where you dispose of all of your The market value of the original units of $9,100 ($10,000 - $900) would be investments at a loss, the proceeds disposed of is $20,000 (16,667 unit deductible. The portion of interest from the sale may not be adequate x $1.2 per unit). That leaves 83,333 that related to ROC from the mutual to pay off the entire outstanding loan original mutual fund units remaining, fund of $36 ($900/$10,000 x $400) balance. In this case, the interest with a total market value of $100,000. would not be deductible since you expense on the remaining portion used it for personal purposes and of the loan will generally continue In this example, only 83.33% of the not for purposes of earning income. to be deductible as long the original source of income acquired with the Assuming you continue to spend loan was used to purchase income original borrowing remains. How the your ROC distributions for personal producing assets. proceeds from the 16,667 original units purposes, your interest deduction will disposed of are used, will determine continue to decrease. Other uses whether the interest on the entire If instead you decide to transfer $100,000 original borrowing remains Alternatively, if you reinvested the a portion of your investments deductible or not. Where the proceeds $900 ROC payment to acquire more to a registered account (such as are used to pay down the original loan, units of the mutual fund or another an RRSP or TFSA), or dispose of interest on the remaining loan would income-producing investment, then your investments and use the sale continue to be 100% deductible. the entire interest expense on the proceeds for personal purposes (such Where proceeds are used to acquire $10,000 of borrowed money should as travel, renovating your home, or another source of income, interest continue to be deductible, so long paying down your mortgage), the on 83.33% of the original loan would as you do not subsequently sell the interest on that portion of borrowed continue to be deductible and interest exact same number of mutual fund funds would cease to be deductible.
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