When interest costs are tax deductible

Are you using your operating line of credit to buy the kids a big-screen TV? Are you also using it to fund your investment activities? Come tax-filing time, this may be a problem.

The cost of borrowing to invest is a legitimate income-tax deduction. The cost of financing the purchase of a TV, however, is not. So, if you want to deduct the interest paid on your line of credit as a carrying charge, you will need to keep your borrowings separate and traceable.

The onus, then, is on you to establish that the borrowed funds are being used for the purposes of earning income — from a business (this is claimed on a business statement) or from an investment in property, real or financial (claim on your Rental Property statement or on Schedule 4 – Statement of Investment Income). The Canada Revenue Agency (CRA) will want to see a direct link between your borrowing and the resulting earnings, although there are some exceptions to this rule.

Remember that interest is not deductible if the loan is used to acquire a life insurance policy or property that produces tax-exempt income, or if you borrow to contribute to a registered retirement savings plan (RRSP), a registered education savings plan (RESP), a registered disability savings plan (RDSP) or a Tax-Free Savings Account (TFSA).

If you borrowed to buy securities — such as common shares or mutual funds — for your non-registered account, you face another hurdle. Because common shares or mutual funds generally do not carry a stated interest or dividend payment, the interest costs on the loan may not be deductible. The CRA will generally allow you to deduct interest costs on funds borrowed to buy common shares if there is a reasonable expectation that those shares will pay dividends, whether or not they are actually do. But each case will be assessed individually upon audit.

You should also know that if the source of the income for which you borrowed no longer exists or has substantially diminished because the investment has lost significant value, you will be able to continue writing off the interest on the loan as if the underlying asset still existed.

It’s Your Money. Your Life. If you must be in debt, make sure the money you borrow is put to work to earn income and your interest payments are clearly traceable. That way those costs will be tax deductible. It makes those interest payments a bit easier to swallow.

Evelyn Jacks is president of Knowledge Bureau, whose curriculum includes wealth-management and income tax-preparation courses. You can also offer Knowledge Bureau financial education books to your clients or family members. For more information, click here.

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