If you think nobody cares if you’re alive, try missing a couple of car payments. It was the late Earl Wilson, an American journalist, who joked about this. There’s nothing like owing some money to ensure others take an interest in you. And whether your debt consists of car loans, a mortgage, line of credit, credit cards or private loans, you’ll save yourself valuable dollars if you can deduct the interest you’re paying. An interest deduction is a sort of silver lining in the cloud of debt you might owe. As you file your tax return this season, are you claiming a deduction for any interest costs? If not, consider setting yourself up for deductions in the future.
I won’t spend time today talking about the rules around interest deductibility, but I will say that, generally, you can claim a deduction when you’ve incurred reasonable interest costs for the purpose of earning income from a business or property. And if you take a look at landmark court decisions on the issue of interest deductions – Singleton v. The Queen (2001) and Lipson v. The Queen (2009), for example – you’ll see a concept that repeats itself. And this concept works in the taxpayer’s favour.
The concept is that taxpayers are allowed to rearrange their 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. Rearranging things this way allows your interest to become deductible. If you’re not able to claim a deduction on your 2018 tax return for interest costs, consider using one of the following ideas to rearrange your affairs to create that deduction for 2019 and future years.
Use “cash damming.” The is the idea of segregating into separate accounts the cash received from borrowing money and cash you might receive from other sources. To create an interest deduction, it’s important to trace your borrowed money to specific income-producing purposes. Although it’s not mandatory that you segregate your borrowed money from other funds, cash damming will allow you to more easily trace the use of the borrowed money. So, for example, you could use a particular line of credit for both personal and income-producing purposes, but transfer the funds that will generate income to a particular bank account first, and then invest those funds to produce income. Use that bank account for income-producing purposes only; this is cash damming.
Make a personal debt swap. If you have cash or other investments on one hand, and debt with non-deductible interest on the other, consider using your cash or investments to pay down that debt, then re-borrow to replace that cash or those investments. The total amount of your debt should remain unchanged, but you should be able to deduct your interest costs on the new debt as long as you’re earning income on your cash or investments.
Complete a corporate debt swap. Assume you have $100,000 of non-deductible debt – perhaps a home mortgage. And suppose you have investments worth, say, $500,000 with an adjusted cost base (ACB) of $100,000. Consider transferring your investments to your corporation (this can be done free of tax using Section 85 of our Income Tax Act; you’ll need a tax pro to help). For making this transfer to your corporation, you will take back in exchange shares in the corporation, plus a promissory note for $100,000 (the note equals the ACB of the investments you’ve transferred to the corporation). Now, you can go to the bank and borrow $100,000 and use that money to subscribe for more shares in your corporation. The interest on this $100,000 should be deductible since you’re borrowing to invest in private company shares. The corporation can then use the $100,000 it receives from your subscription to pay off the note owing to you. You can then use that $100,000 of cash to pay down your non-deductible debt.
“Fill the hole” in your corporation. You can arrange for your corporation to borrow money to redeem shares you own, return capital to you that you’ve invested in the corporation, or pay dividends. In this case, your company is generally entitled to deduct the interest costs because the borrowed money is being used to “fill the hole” left by the payments made to the shareholders. That is, the borrowed money is being used to replace capital being used for purposes that would give rise to interest deductions. You can then use the cash paid out to you to pay down non-deductible debt you might have.
Tim Cestnick, FCPA, FCA, CPA(IL), CFP, TEP, is an author, and co-founder and CEO of Our Family Office Inc. He can be reached at firstname.lastname@example.org.