Last week I shared the story of Nina Sherle. Ms. Sherle owned a principal residence and a rental property. She owned her residence free and clear without any debt secured by the property. She had taken out a mortgage to purchase the rental property and was able to deduct her interest on that mortgage since the property earned rental income. That is, she directly used the mortgage proceeds for the purpose of earning income, so the taxman allowed the deduction for her interest costs. She then swapped the properties so that her principal residence became a rental and her rental became her principal residence.
Ms. Sherle still wanted to own her residence (the former rental) free and clear of debt, so she borrowed funds against the new rental property (her former home) and used the proceeds to pay off the debt on her new residence (the former rental). Follow me? CRA then denied Ms. Sherle her interest deduction going forward. They went to court over the issue, and CRA won the battle in court.
I mentioned last week that your intention or purpose for borrowing money is irrelevant when it comes to deducting interest. Further, the assets you pledge as security for the debt are also irrelevant. All that matters is direct use of the borrowed money. So, what could Ms. Sherle have done differently to enable a deduction for her interest? More importantly, what can you do today to ensure that you’re entitled to deduct interest on your debt? Here are a few ideas:
1. Sale to a friend: Ms. Sherle could have sold her principal residence to an accommodating party – say, a friend or relative – in exchange for a promissory note. She could have then borrowed money from the bank to repurchase that property from her friend or relative. Her friend or relative could have then used the cash to repay the promissory note owing to Ms. Sherle. If Ms. Sherle then used the property to earn rental income (as she did), then she would have been able to deduct the interest on the new debt.
2. Sale on the open market: Suppose you have non-deductible interest on some debt. If you have other cash or marketable securities available, consider taking that cash or selling those securities for cash, using the cash to pay down your non-deductible debt, and then borrowing to invest in new assets (perhaps replace those same securities you just sold) with a purpose of producing income. Presto, you should be able to deduct your interest costs now. Just be sure to count the tax cost associated with selling any marketable securities beforehand. If you don’t like the tax hit you’re going to face when selling those securities, consider the next idea instead.
3. Transfer to a corporation: Suppose you have non-deductible interest on some debt and you have other assets, perhaps marketable securities available. Consider transferring those assets to a corporation (even if these assets have appreciated in value there should be no tax to pay if you make an election under Section 85 of the Income Tax Act when making the transfer; see a tax pro). In exchange, take back a promissory note for the cost amount (that is, the adjusted cost base) of the assets transferred (the promissory note cannot be for more than the cost of those assets, otherwise you could trigger some tax). Then, borrow funds from the bank to subscribe for more shares in your corporation. The corporation can use the new cash to pay off all or part of the note owing to you. You can then use the cash to pay down your non-deductible debt. You should now be able deduct the interest on the new debt since the proceeds are used to invest in shares of your company.
4. Take out paid-up capital: Once again, suppose you have non-deductible debt. Suppose you also own shares in a private corporation and you have “paid up capital” in those shares (generally, you’ll have paid-up capital in shares to the extent you have subscribed for those shares using cash). Your corporation can then make a tax-free return of all or some of that paid-up capital to you (see a tax pro for different ways to do this). You can then use that cash to pay down your non-deductible debt. Finally, you can then borrow funds to reinvest in more shares of the corporation, or to lend money to the corporation (even at zero interest; CRA’s Interpretation Bulletin IT-533 confirms that interest will generally be deductible in this case).