If you pay interest on money borrowed to earn investment income, you can claim a deduction for the interest paid as a carrying charge. That’s quite lucrative as the deduction offsets all other income of the year and can help to reduce net income, the figure upon which certain government benefits, like the Canada Child Benefit, are based. But, the claim is not as straight-forward as you might think.
First, there must be a reasonable expectation that the invested funds will generate a return on the investment, in excess of the cost of borrowing the money – i.e. there must be a reasonable expectation that “income from property” can be from the investment. This means that the investment has the potential to earn interest, dividends, rent or royalties, which will be reported as income on the tax return. Despite the deduction, if you borrow money at 6% to invest in a property with an expected rate of return of 3%; you may not come out ahead.
With one exception – publicly traded shares that have the potential to earn income – if the investment will only earn capital gains on disposition, then the interest paid on money borrowed to purchase the investment is not deductible as a carrying charge, although it may be added to the cost base of the asset to reduce the capital gains tax when the asset is disposed of.
For interest paid on money purchased to earn income from a business, the interest is a business expense.
Where things get tricky is when the money borrowed cannot be linked directly to the earning of investment income. This can happen when the borrowed funds are used for both personal and investment purposes. A common example is the use of a line of credit for both investing and paying personal expenses. As much as possible, comingling of borrowings for personal and investment purposes should be avoided so that it is clear that the money borrowed was used to earn investment income.
CRA has provided an example of this in its Folio S3-F6-C1 Interest Deductibility:
“Assume an individual has a $100,000 line of credit. The individual uses $60,000 for personal purposes and $40,000 to acquire income-producing property. Accordingly, 40% of the line of credit is used for eligible purposes. Where a repayment of a portion of the borrowed money occurs, it will be necessary to apply this percentage to the remaining balance of the line of credit to calculate how much interest is deductible. If the individual makes a $20,000 payment, the balance on the line of credit will be $80,000. The individual cannot allocate the repayment specifically to the ineligible portion of the borrowing. Instead, applying the original eligible use percentage to the balance, interest on $32,000 of the borrowed money (being 40% of $80,000) will be deductible.”
Also of note is that a recent Federal Court of Appeal decision, in the case of Van Steenis v. Canada. It upheld a decision by the Tax Court of Canada in a case where a taxpayer borrowed to invest in mutual fund units and subsequently received a return of capital from the mutual fund, some of which he then used for personal purposes. The court’s findings were that the funds originally used for investment purposes were no longer being used 100% for investment purposes and therefore the interest on the funds was no longer 100% deductible. The courts found that the return of capital was actually part of the money invested and, therefore, unless the return of capital was used to pay down the loan or to purchase other investments, the money borrowed was no longer being used to earn investment income.
The take away for investors who borrow money to purchase mutual fund units is that, if they want to continue to deduct the interest paid on the money borrowed, they must use any return of capital to either repay the money borrowed or they must re-invest it. This, of course, does not stop the investor from using any income earned on the funds for personal purposes.