The real estate market’s appreciation over the past several years has significantly increased the equity of Canadian property owners, but accessing that equity can create a tax predicament, as the following two scenarios illustrate.
Case 1: The Nestors
The Nestors own a personal residence as well as a rental property with significantly appreciated value. They have small mortgages on both properties, and mortgage interest on the rental property is tax-deductible. The Nestors would like to help their adult son, George, purchase his first home and are considering refinancing either the personal residence or the rental property to fund the down payment.
Without any professional advice, they choose to refinance the rental property to provide George with the necessary funds, believing they can deduct the increased interest costs associated with the renewed mortgage.
Case 2: The Devis
The Devis moved to Canada and purchased a home 20 years ago. They worked hard to pay off the mortgage and would like to upgrade to the dream home they’ve always wanted while converting their current home to a rental property.
Without any professional guidance, the Devis refinance their current home and use the funds to make a significant down payment on their dream home. They believe that since the mortgage is placed on the current home that has been converted to a rental property, they will be entitled to an interest deduction against the rental income that the property generates.
Interest deductibility rules
The rules for interest deductibility are found in paragraph 20(1)( c ) of the Income Tax Act. There are four conditions that must be met for interest to be deductible:
- There is an obligation to pay the interest costs.
- The interest costs must be paid or payable during the year.
- The interest costs are reasonable.
- The borrowed money must be used to earn income from a business or property.
The first three conditions are straightforward and easy to meet. The fourth is the key to interest deductibility: it has caused much confusion over the years and been the subject of many court decisions. In Income Tax Folio S3-F6-C1, Interest Deductibility, the Canada Revenue Agency (CRA) provides an in-depth summary of its position on when interest is tax-deductible under a variety of circumstances based on past court decisions.
A key element to interest deductibility is the concept of “tracing” or “linking” the borrowed money to an income-producing purpose. More specifically, the CRA will base interest deductibility on the current use — not the original use — of borrowed money. This means borrowed money that was tax-deductible in the past may not necessarily be tax-deductible in the future.
How does the tracing or linking concept impact the Nestors and the Devis?
The Nestors refinanced their rental property to extract money to help their son, George, buy his first home. Using the tracing or linking principle established by the courts and the CRA, the current use of the money will determine if interest is tax-deductible. Since the current use is linked to George’s personal residence, interest on the borrowed money used to purchase George’s home isn’t tax-deductible. The fact that a rental property is used as collateral to obtain the loan is of no consequence in determining the interest deduction. Therefore, interest on the portion of the loan used to help George buy his first home isn’t tax-deductible.
The result is similar in the Devis’ situation. They used the equity in their current home to help fund the purchase of their dream home. Although their original home has been converted to a rental property, the tracing principle connects the current use of the borrowed money to the purchase of the new principal residence (i.e., dream home), which isn’t an income property. As a result, the interest costs on the borrowed funds aren’t tax-deductible.
Note that there are also possible tax implications with converting the principal residence into a rental property.
These examples highlight how easy it is to fall into the trap of expecting an interest deduction when there isn’t one. More importantly, they highlight the need to obtain professional tax advice prior to these types of transactions to determine if steps may be taken to link the borrowed money and the income in order to maintain interest deductibility.