People often borrow money from their friends, family, or from a financial institution to either fund a real estate purchase or make an investment. There are times when taxpayers will borrow money to purchase a good mutual fund investment or shares of a company. The money borrowed often requires that the taxpayer pay a sum as ‘interest’.
Often the person borrowing is surprised to know that this interest portion may be deductible for tax purposes. Given the confusion surrounding the treatment of borrowed money by the Canada Revenue Agency (CRA), AG Tax analysts have prepared a brief summary regarding this topic. As always, please consult your personal tax advisor for tailored recommendations based on your personal tax situation.
When is Interest on Borrowed Money Deductible?
As per the Canadian Income Tax Act (ITA), interest paid on borrowed funds is deductible if it is paid in the tax year, or in respect of the year where a taxpayer is supposed to pay interest as part of a court order. Also, it should not be more than the actual amount, and should be an acceptable amount which is to say that you can only deduct interest you actually pay and it must be at a reasonable rate. Beyond this there are criteria depending on the type of investment the funds were borrowed for as follows.
Interest on Money Borrowed for Real Estate or Other Investments
Whenever interest is payable to an entity (resident/non-resident) on money borrowed to earn business and/or property income (even if it is a barren land providing rental income), the interest is tax deductible. However, a net loss (interest in excess of the income from the property), cannot be claimed. Any interest expense or property taxes in excess of the income from the property may potentially be added to the purchase cost of land and improvements or structures to arrive at the ‘adjusted cost base’ (ACB). The ACB is then used to reduce the capital gain when the land is sold. Please be informed that if money has been borrowed for improvements, renovations, additions, or any modifications to the rental property, special rules apply to the interest payable on that money.
Interest payable on money borrowed for buying securities, bonds and other investments is tax deductible provided that these investments are earning income in the form of interest or dividends. This is the case even if the dividend is receivable at a future date.
In the event that an investment is maintained only to earn an eventual capital gain, or if the corporation issuing the shares discloses that it will not be paying dividend income, then the interest on money borrowed to purchase such an investment is not tax-deductible.
What if the Security/Investment is sold but the Seller is still Incurring the Interest Expense?
If the security/investment is sold at a loss and the seller is still incurring the interest expense on the money borrowed to purchase the investment. This interest expense is still deductible.
Let’s assume that a Canadian taxpayer purchased $5,000 worth of a corporation’s shares with borrowed money, and sold it at a loss with the owed amount still in place.
If the shares are sold for $2,000, which is then used to purchase another investment or any other income producing property; the entire loan amount of $5,000 is still deductible until paid off.
However, if the sale proceeds of $2,000 are utilized to purchase a personal property then the interest on $2,000 of the borrowed amount is not tax deductible but the interest on the remaining sum of $3,000 is still tax-deductible.
The interest expense qualifies for deduction even if the sale proceeds are utilized to partially pay off the debt.
That being said, the interest expense can also be carried forward or carried back as non-capital loss to reduce the taxable income.
Taxpayers who have borrowed money to purchase real estate investments or other securities, and incur interest expenses, should consult a tax professional to understand the exact tax treatment of such an expense based on their individual tax situation.
AG Tax LLP Can Help
If you have any tax-related queries or need assistance with tax planning or filing please contact AG Tax. Our tax professionals are highly-experienced with U.S. and Canadian tax laws and can provide you the right guidance to handle your tax situation.
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