Tax deductibility of interest on an investment loan

The tax deductibility of interest charged on an investment loan depends on a number of factors, with the Income Tax Act (Canada) providing the framework for determining the interest. This framework has been interpreted in numerous court cases over the years, some of which have shaped the landscape of interest deductibility as we know it today.

Effectively, the Income Tax Act (Canada) provides three basic criteria to determine whether interest is deductible:¹

• Interest must be paid or payable.
• Interest costs must be reasonable.
• Interest must be paid for gaining or producing income.

Interest must be paid or payable

For interest to be deductible, there must be a legal obligation to pay the interest. In other words, the lender must have the right to enforce payment of principal and interest on a loan.

If the cash method (i.e., an individual) of reporting income is used, the interest may be deducted in the year in which it’s paid. Conversely, if the accrual method (i.e., a business) of reporting income is used, the interest may be deducted in the year it becomes payable even if it’s not yet paid. However, compound interest is only deductible when it’s actually paid.

Interest costs must be reasonable

Interest will be deductible only if it’s reasonable in the circumstances. In most cases, the reasonableness requirement will be fulfilled if the interest rate that applies to the borrower is the same as or similar to the market rate of interest that applies to borrowers with similar credit risks in similar circumstances. The Canada Revenue Agency (CRA) can deny interest deductions in excess of a reasonable amount.

Interest must be paid for gaining or producing income

To be deductible, interest must be incurred for the purpose of earning income from a business or property. More specifically, there must be a reasonable expectation of earning income at the time the investment was made with the borrowed funds. It’s important to note that capital gains aren’t considered income. However, in the case of an investment such as mutual funds or securities, where the primary objective of borrowing is capital growth, it would be possible to deduct the interest as long as there’s also an expectation to earn income (i.e., interest or dividends).

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When these three criteria are met, the interest paid or payable in the year can generally be deducted against income. Investment funds have variable rates of return that could be more or less than the borrowing interest rate. Nonetheless, the full amount of interest should still be deductible even in a year when interest expense exceeds the investment income. (For residents of Quebec, refer to the “Investment expense deductibility: Quebec” section below.)

Although the three basic criteria outlined provide the basis for interest deductibility, there are a number of additional factors to consider when borrowing money to invest and determining whether the interest on this borrowed money can be deducted.

Interest on borrowed money used to earn exempt income,² to acquire a life insurance policy, or to make a contribution to a deferred income plan—such as a registered retirement savings plan (RRSP), registered pension plan (RPP), registered education savings plan (RESP), deferred profit savings plan (DPSP), first home savings account (FHSA), or tax-free savings account (TFSA)—won’t be deductible.

As indicated above, interest on funds used to acquire a life insurance policy won’t be deductible. However, the Income Tax Act (Canada) provides an exception if the borrowed money is used to purchase a non-registered segregated fund contract.³ Under these circumstances, interest on borrowed funds is deductible.

Where cash distributions are received from an investment and these amounts include a return of capital, the CRA views this as a portion of the investment being withdrawn and returned to the investor. Where a loan was obtained to acquire the investment and the cash distribution of return of capital is used for personal use, the CRA considers this a reduction in the amount of the loan that’s used to earn income from property, and therefore, there’ll need to be a proportionate reduction in the amount of loan interest deducted.

If borrowed money stops being used for income-earning purposes because the source of income is gone, interest paid on the borrowed money may continue to be deductible.⁴ For example, with respect to the sale of an investment, if the fair market value of the investment has dropped below the adjusted cost base and the proceeds are used to pay down the associated debt, interest may continue to be deductible on the remaining debt despite the asset being disposed of.

Tracing of funds is fundamental to determining interest deductibility. It’s the responsibility of the borrower to keep proper records for tracing the funds to a current eligible use. In situations where it’s not possible to trace the borrowed money to its various uses, the borrower risks losing the interest deduction.

The CRA has indicated that a flexible approach could be allowed to trace the borrowed money to an eligible use if the borrowed money is commingled in an account with cash. However, this approach doesn’t apply to tracing or allocating repayments of money that was borrowed for various uses under a single line of credit to specific eligible or ineligible uses. In this situation, a constant prorated portion based on initial eligible vs ineligible uses must be used. Therefore, under current assessing practice, dedicated credit facilities for investment purposes should be used to make sure that any interest incurred will be deductible.

Quebec limits the deductibility of investment expenses incurred by an individual or trust to the amount of investment income earned during the year. The limitation on the deductibility of investment expenses applies to those expenses incurred to earn income from property, other than rental income. Investment expenses incurred to earn active income, such as income from a business or income from rental of an asset, aren‘t subject to this limitation. For a more detailed discussion on the Quebec provincial tax treatment of investment expense deductibility, read “Investment expense deductibility: Quebec.”

It‘s important to consider the implications when borrowing funds to invest. Each situation should be dealt with based on the particular facts involved to determine if interest is tax deductible. Speak to your advisor to see if this strategy is right for your situation.

1 Paragraph 20(1)(c) of the Income Tax Act (Canada) provides the basic criteria for interest deductibility. 2 Exempt income is defined in subsection 248(1) of the Income Tax Act (Canada). 3 Subsection 20(2.2) of the Income Tax Act (Canada) provides an exception for a non-registered segregated fund policy. 4 Section 20.1 of the Income Tax Act (Canada) provides a rule for the loss of source of income.