Welcome back to the blog!
In addition to working with clients on investment and wealth management, I write a blog on tax tips and tidbits and share other articles that I think will be of interest.
In this edition, I’m going to write about how you might be able to structure your personal mortgage on your principal residence to make the interest tax deductible.
Starting with the facts
In 2025, it is expected that there will be 1.2 million fixed rate mortgages up for renewal in Canada according to a CMHC report.
Now although the monetary policy easing cycle is well under way with the Bank of Canada overnight rate now sitting at 3.25 percent, which is down from 5.0 percent just 8 months ago, this is still significantly higher than the 0.25 percent rate in effect when the majority of these mortgages were initially advanced.
As a result, a lot of folks with mortgage renewals this year are going to have to navigate a rate environment that looks very different where the default expectation is a significantly higher interest rate and therefore higher monthly mortgage payment.
So when is interest tax deductible?
In the United States, the IRS allows individuals to deduct mortgage interest up to certain limits without any cute or complex tax planning.
The Canada Revenue Agency isn’t so generous, and as such, mortgage interest on a principal residence is generally not deductible as the Income Tax Act considers interest to be a capital expense. In Canada, there are very specific requirements that must be met in order to be able to deduct interest as follows:
- The borrowed funds must have been acquired for the purpose of earning income from a business or property, which includes interest and dividends, however, not capital gains.
- The interest rate must be reasonable in comparison to prevailing market rates for debts with similar terms and credit risk.
- The interest must accrue or be paid in the year the deduction is claimed.
- There must be a legal obligation to pay the interest.
How do you make the interest tax deductible on a principal residence?
So, at this point, you might be wondering how you can turn your principal residence into a business or income generating property to be able to deduct the interest?
However, this is not what you actually want to do assuming that you wish to ensure that your home continues to qualify as your principal residence such that future capital gains on a sale are tax free.
Here is a simple example of a strategy that you may wish to actually consider:
- Assume that you have a mortgage on your home or cottage.
- Next, you need cash available to repay all or a portion of the mortgage, however, be sure to review pre-payment penalties if applicable or consider initiating this strategy at the mortgage renewal date.
- If you aren’t sitting on a pile of cash from a bonus, inheritance, or a recent lottery win, you may instead have investments in a non-registered investment account. If you do, consider selling some of these investments to the extent necessary to pay off the desired amount of the mortgage.
- Immediately thereafter, re-borrow the same amount that you just paid off on your mortgage and invest the cash back in your non-registered investment account.
- Now there is a direct link between the new mortgage and the investments such that the purpose of the mortgage is to earn income. Therefore, the mortgage interest will be deductible on your tax return subject to the caveats outlined below.
There are several other variations of the above debt swap strategy referred to as the Singleton Shuffle or the Smith Maneuver, which either involve drawing against a capital account in a partnership or a line of credit and using the tax refund to pay down the mortgage, however, the idea is very similar to the strategy described above.
What else do you need to consider?
In the unlikely event that you are a tax nerd, the CRA recently updated its folio on interest deductibility, which can be viewed here, where there is significantly more detail on all the nuances of interest deductibility for late night reading.
Now for everyone else, there are several non-exhaustive considerations to be aware of that I have highlighted below.
- If you are selling non-registered investments, ensure that you consider the potential unrealized capital gains that may be triggered.
- If the interest is incurred on funds borrowed to invest in registered accounts, including RRSPs, TFSAs, FHSAs, RESPs, or RDSPs, the interest will NOT be deductible for tax purposes.
- If the investments purchased with the mortgage proceeds do not currently pay interest or dividends, there needs to be a reasonable expectation that they may in the future to meet the purpose test as capital gains alone are not sufficient.
- If you plan to draw cash flow from the investments purchased with the mortgage proceeds, this should be limited to dividend or interest distributions in order to ensure that the full amount of interest continues to be deductible.
- If the investments purchased with the mortgage proceeds pay out distributions in the form of a return of capital, things can get a little tricky as detailed in a recent Federal Court of Appeal case. In order to ensure the full amount of interest remains deductible, the return of capital distributions should continue to be invested versus being used for personal purposes.
Finally, please consult your tax advisor before proceeding with any variation of this type of planning!
If you have questions I can be reached at craig.dale@rbc.com or 604.981.6680.
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