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Miss Take Part One: Interest Deductibility Considerations When Converting Your Principal Residence to a Rental Property

08/12/2012


The Story of Miss Take

A number of years ago, Miss Take purchased her principal residence with help from her bank. A lot of hard work and countless mortgage payments later Miss Take is now mortgage-free. As is often the case, Miss Take finds that the old house isn’t really satisfying her needs anymore and she’s looking to move to a bigger and better home. The old home has increased substantially in value and Miss Take has developed a certain affinity for the place so she has decided to keep the house and rent it out.

Relying on her equity in the old house, back to the bank she heads to take out another mortgage on the old place to buy her new home. The mortgage interest paid on the old house will go a long way in sheltering from income tax the rent Miss Take receives. It should be smooth sailing ahead, or so she thinks.

Everything seems just fine until Miss Take pays a visit to her accountant to get her personal tax return completed. After reviewing the facts, the accountant has determined that Miss Take has fallen victim to the “big mistake” – what seemed like very logical steps to follow at the time have left Miss Take with taxable rental income but non-deductible mortgage interest – clearly not the most desirable outcome.

What do you mean non-deductible interest? She did borrow against the rental property after all, didn’t she? How can this be?

A Backgrounder

The error in Miss Take’s game plan is her assumption that conversion of her former principal residence to a rental property and placing a mortgage on that same property to buy her new home will result in tax-deductible interest. Unfortunately for Miss Take, this is not the case. Although greatly simplifying the issue, provided the amount is reasonable, interest paid is generally deductible for income tax purposes under the following conditions:

  1. The interest was paid or payable in the year in accordance with a legal obligation, and
  2. The borrowed funds were used for the purpose of earning income from a business or property – the term “property” referring to interest income, dividends, rents and royalties but not capital gains.

The first condition rarely causes problems because most loans are properly supported by a written agreement but the same can’t be said for the second condition.

The Canada Revenue Agency has produced an Interpretation Bulletin, IT-533 Interest Deductibility and Related Issues, which provides its interpretations of the deductibility of interest expense under various provisions of the Income Tax Act and the judgments in numerous court decisions involving the deductibility of interest expense.

The Bulletin states that “the test to be applied is the direct use of the borrowed money. In certain circumstances, however, the courts have stated that indirect use will be accepted as an exception to the direct use test.

In determining what borrowed money has been used for, the onus is on the taxpayers to trace or link the borrowed money to a specific eligible use, giving effect to the existing legal relationships.”

Applying this “trace or link” test to Miss Take’s situation it’s clear that the borrowed funds were used to purchase her new principal residence. The fact a rental property was used as collateral for her loan is of no consequence; all that matters is the use made of the borrowed funds. In this case, she clearly used the borrowed funds to purchase her new principal residence and, as we all know, interest paid on debt incurred to purchase a principal residence is not deductible for income tax purposes. The end result for Miss Take will be taxable rental income and non-deductible interest expense – clearly not a very good outcome. The problem here is the taxpayer has confused the security for the new borrowing with the use of the borrowed funds. In this case, the security for the loan does not matter – it’s the use of the borrowed money that counts.

The Solution

So what could have been done differently here to provide tax deductible interest expense for offset against the rental income received? Consider the approach taken by Rita Ohn who has paid-off her existing home and now wants to buy a new home and commence renting her own home. Knowing the importance of “tracing” in the deductibility of interest, Rita took the following steps, in order, and at fair market value:

  1. On day one, Rita sold her current home (the “old home”) to her parents for fair market value. Rita’s parents paid for the purchase by issuing a promissory note to Rita. Always concerned about property transfer tax and other matters, Rita discussed this series of transactions with her lawyer who ensures all steps are properly documented;
  2. On day two, Rita reacquired the “old home” from her parents by borrowing from the bank on the security of a mortgage. Rita plans to use the “old home” as a rental property;
  3. Rita’s parents use the funds received to repay the promissory note they issued to Rita on day one, and
  4. Rita then uses the funds received from her parents to purchase her new home.

When the dust settles, Rita owns a rental property (the former “old home”) and she also owns a new home. Following the “tracing” principle Rita can clearly show that the money she borrowed was used to purchase a rental property and, therefore, the interest paid should be deductible against the rental income she receives in the calculation of her taxable income.

This example shows that a few simple steps can result in a very different outcome – in Rita’s case, an outcome that provides her with tax deductible interest expense.