It's not often that you'll find money coming as a tax-free windfall. A few years ago, some taxpayers in Washington, D.C., were given an average of about $30,000 (U.S.) by merely forgoing the right to alter the façade of the buildings they owned, which were historical properties. The crazy thing was that D.C. law already restricted alterations to these buildings. The windfall came in the form of a tax deduction that could be claimed by qualifying taxpayers.
I'm still looking for that type of windfall here in Canada. I thought that the "Odour Control Tax Credit" (it's real – honest) might be just the thing, but it turns out I don't qualify because I don't live in Manitoba, and I'm not creating any odours that require controlling. And so, like most Canadians, I'm left to create my own windfall. It's worth looking at interest deductions as one option. Let me share some ideas.
I've written before about the rules around interest deductibility (see my article dated July 11, 2012). Generally, you can claim a deduction when you've incurred reasonable interest costs for the purpose of earning income from a business or property. There's one concept that has repeatedly shown up in court decisions in favour of the taxpayer. In fact, the Supreme Court of Canada reminded us of this concept in the cases of Singleton v. The Queen (2001) and Lipson v. The Queen (2009).
Here's the concept: There's nothing wrong with a taxpayer rearranging his or her affairs so that borrowed money is used to finance the purchase of income-producing assets while cash, or other equity, is used to finance the purchase of personal (non-income-producing) assets. By doing this, interest generally becomes deductible. Now, let's take a look at some specific ideas that can accomplish this.
Personal debt swap. If you have cash or investments on one hand, and debt with non-deductible interest on the other hand (perhaps a home mortgage), consider using your cash or investments to pay down your debt. Then, reborrow to replace that cash or those investments. Your total debt will remain unchanged, but you should now be able to deduct your interest on that newly borrowed money as long as you're earning income on your cash or investments.
Spousal debt swap. Suppose you have a spouse under our tax law. Let's assume a husband-and-wife scenario. Assume the husband owns an income-producing asset (an investment portfolio, private company shares etc.). He sells the asset to his wife for fair market value – say, $500,000. She borrows the $500,000 to pay for the asset (call this Loan 1). She's now deducting her interest on Loan 1 because she used the funds to buy an asset that earns income. There will be no tax to pay on the sale to his wife because transactions between spouses are deemed to take place at adjusted cost base (ACB) (unless you elect otherwise). The husband now takes the $500,000 and either purchases a personal asset in joint names (a home, for example) or pays down existing non-deductible debt on a personal asset (perhaps an existing home mortgage).
The husband and wife then borrow $500,000 from the bank (Loan 2) using the personal asset as collateral, and use the proceeds to pay off the wife's $500,000 loan (Loan 1). The interest on Loan 2 should be deductible since the proceeds are used to pay down debt that is already deductible (Loan 1). A couple of last points: Any income earned by the wife on the income-producing asset she now owns will be attributed back to her husband under our tax law, and the wife will claim the interest deduction here (so she needs sufficient income to absorb that deduction).
Corporate debt swap. Suppose you have $100,000 of non-deductible debt – say, a home mortgage. And you have investments worth some amount – say, $500,000 – with an ACB of $100,000. Consider transferring your investments to your corporation (you can make this transfer tax-free under Section 85 of our tax law; you'll need a tax pro to help). As part of this transfer, you'll receive from your corporation, in exchange, more shares in the company plus a promissory note of $100,000 (the note equals the ACB of the investments you're transferring). Now, go to the bank and borrow $100,000 to subscribe for more shares of your corporation. The interest should be deductible because you're investing in shares. The corporation can use the $100,000 to repay the note owing to you. You can then use that cash to pay down your non-deductible debt.
Tim Cestnick, FCPA, FCA, CPA(IL), CFP, TEP, is an author and founder of WaterStreet Family Offices.