Interest on personal loans represents a significant expense, but there are ways to structure these loans that let you deduct the interest for tax purposes.
Under Canadian tax rules interest on borrowed money used for the purpose of earning income is generally deductible. Interest on a personal loan, like a mortgage, for example, is not tax deductible.
Read: Beware leveraged loans
So, interest deductibility depends on the use of the borrowed funds; and Revenue Canada places its emphasis on the direct use of the funds, as opposed to the overall purpose of the borrowing.
This so-called “direct use test” lets people, in certain circumstances, with sufficient business or investment assets reorganize their affairs to effectively convert what would otherwise be non-deductible interest into deductible interest.
A business owner holds a non-registered investment portfolio with a fair market value of approximately $3 million, and the securities within the portfolio provide him with a reasonable expectation of income.
He’s planning to buy a cottage for $1.5 million, which exposes him to a lot of interest costs because mortgage loans aren’t deductible. With some careful planning, though, he could essentially convert the interest on the mortgage into deductible interest.
How? He would sell $1.5 million of securities from his investment portfolio and buy the cottage with the proceeds (he’d have to deal with either a capital gain or loss depending on the markets). He’d then use the borrowed funds (which would be secured against the cottage) to repurchase the securities. This way, the direct use of the borrowed funds would be the purchase of securities, and Revenue Canada would consider these funds for the purpose of earning income.
This example is based on a Supreme Court of Canada decision, Singleton v. Canada (2001 SCC 61), in which the plaintiff withdrew cash from the capital account in his law practice to buy a home. That same day, he borrowed money from a bank to replenish his capital account. The Supreme Court ruled that although the ultimate purpose of the loan was to buy a house, the direct use of the borrowed funds financed an income-producing asset. Therefore, he was entitled to deduct the interest on the loan. More-recent rulings have concurred.
Is it tax deductible?
The test to determine whether a person has an “income-earning purpose” for taking a loan is if there is a reasonable expectation of income at the time the investment was made. It refers to gross income, not net income or profit. Here are some examples of investments that will pass the test:
- Assets used in running a business
- A rental property
- Interest-bearing instruments (such as GICs, bonds, or treasury bills, that carry a stated rate of interest return)
- Shares of a corporation, where there’s a reasonable expectation they’ll pay dividends (even if the dividend expectations are low)
- Units/shares of a mutual fund, where there’s a reasonable expectation of distributions of income (as opposed to distributions of capital, which do not qualify as income)
This article was originally published on capitalmagazine.ca.