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Tax Matters

When interest costs aren't deductible Add to ...

A gentleman recently approached me because the Canada Revenue Agency had denied him a tax deduction for child care expenses. “Did you respond to CRA before calling me?” I asked. Turns out he had written several letters to the taxman. Each letter showed increasing frustration.

In his most recent letter, he wrote: “Dear Madam: I am responding to your letter denying the child care deduction on my 2009 tax return. Thank you very much. For years, I have questioned whether this young person belonged to me. He is of questionable character, funny looking and expensive. Regarding Jason, who is 9 years old: He has beady eyes, and I suspect he may become a tax auditor one day – unless someone incarcerates him first. Henceforth, Jason is now under your care since he is not mine.”

Deductions of all types denied by CRA can drive anyone crazy. Fortunately, we can learn from the misfortune of others who have battled CRA in court over deductions. Today, I want to share with you a story about deducting interest costs, because this is one of the most commonly misunderstood tax deductions.

The story

Nina Sherle owned a home in Vancouver from 1985 to 1994. It was her principal residence and was free and clear of any mortgage or other debt. Let’s call this “Property V” (for “Vancouver”). She also owned a second property in Burnaby, which she and her husband had purchased in 1993, that was a rental property. Let’s call this “Property B.” There was a mortgage on Property B, and the interest was deductible since the borrowed money was used to earn income from Property B.

In mid-1994, Ms. Sherle decided to switch the properties around so that Property V became a rental property and Property B became her family’s principal residence. She did not want to switch her financing goal, which was to own the principal residence free of any debt. So, Ms. Sherle mortgaged the property they were leaving (Property V) and paid off the mortgage on their new residence (Property B). The result? Ms. Sherle made interest payments on a mortgage on Property V, which was the rental property after the switch. She then claimed a deduction for this interest cost under paragraph 20(1)(c) of the Income Tax Act because, in her view, the money was borrowed for the purpose of earning rental income.

Here’s the problem: Ms. Sherle was denied her interest deduction. She appealed this decision to the Tax Court of Canada. Her argument was that the purpose of the mortgage on Property V was to enable the switch of properties and to turn Property V into an income-producing property. Without this financing, she would not have made the switch.

Her argument makes some sense since the economic reality was that she still owned a residence and a rental property, and she had legitimately been able to deduct interest in the past due to her rental income. Why should that change when, in reality, she still owned the same properties? The problem, of course, is that our tax law and the courts have a different view.

The decision

In this case, CRA argued that the actual use of the money that was borrowed was to pay off a mortgage on Ms. Sherle’s new principal residence (Property B), and therefore the borrowed money was not used for the purpose of earning income. Technically, that is in fact what she used the new mortgage proceeds for; she paid off the mortgage on Property B – her new principal residence.

In the Sherle case, the court sided with the CRA. The judge made reference to other court rulings, a couple of which are considered to be landmark decisions on the issue of interest deductibility. In the Singleton and Lipson decisions, the Supreme Court of Canada established the principle that it is the direct and immediate use of the borrowed money that should determine the purpose of the loan. If the purpose is to gain or produce income, then the interest should be deductible – otherwise, you’re out of luck, as was Ms. Sherle.

The bottom line? 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. Next week, I’ll talk about what Ms. Sherle could have done differently – and what you might do to ensure interest deductibility.

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