I am not a tax advisor, and if you have read some of my other articles or sections on my website, you will have noted that I always stress how important it is to obtain competent independent financial / tax advice in any area concerning the use of a mortgage when it comes to tax considerations.

Please be aware that, as with all tax-planning strategies, there is always the possibility that the rules will change, possibly rendering a particular tax-reduction strategy less effective, or even worthless.

I have written before on the issues concerning converting your principal residence into a rental property. I have pointed out that in one case Revenue Canada ruled against an Ontario couple whom they deemed to be guilty of tax avoidance in using such a manoeuvre.

In essence there are three issues concerning the reduction of tax:

  1. Tax Reduction (allowable)
  2. Tax Avoidance (questionable at best)
  3. Tax Evasion (illegal)

The issue here is the intended, or actual, use of funds derived from a mortgage on your principal residence.

I know of several people who have bought a property, paying in full, and subsequently obtained a mortgage. This may have been to start a business or for investment in equities.

This is fine, and in such cases the interest on the mortgage is tax deductible, but…. here’s the potential problem:

It would be very easy to assume that the same rules would apply if the mortgage funds were used to buy another property.

But Revenue Canada says not so!

The tax deductible opportunity does not apply to capital gains.

Please see Canada Revenue Agency’s “Interpretation Bulletin, IT-533 Interest Deductibility and Related Issues” for the full story. It provides an interpretation of the deductibility of interest as covered by different sections of the Income Tax Act and several related judgments and court decisions.

There is some confusion as to whether the mortgage funds must be applied directly to the purchase or investment opportunity. And while the courts have stated that indirect use is acceptable it is always possible that a ruling in this situation could go against you.

The onus is on you to keep meticulous records showing the use of the funds in question.

The bottom line is that interest paid on debt incurred to purchase a principal residence is not deductible for income tax purposes.

So if you borrow against a rental property and invest in a principal residence you will end up with be taxable rental income and non-deductible interest expense.

Remember, the key point here is the “use” of the borrowed funds, not where they came from.

A number of solutions have been documented in an effort to address a solution. Having reviewed them, I have to say that while the use of these methods may be legal per se, none of them can prevent Revenue Canada from deciding that what you have done was simply to avoid paying taxes.

One last time…. You must get competent, independent, professional advice in these matters.

(Copyright Dara Fahy. All rights reserved.)