Interest Deduction For Personal Investments
While many Canadian individuals are familiar with the ability to make various deductions to their income to reduce their tax burden one method that is often overlooked and more commonly misunderstood is the ability to deduct interest costs associated with their investment portfolios. In general, when an individual borrows money for the purpose of earning investment income, that interest expense is typically tax deductible.
It should be noted that while borrowing to invest can be an effective way to enhance the growth on an investment portfolio, it is still a very risky endeavour and one should always consult a tax specialist before implementing such a strategy. Below are some of the basics one should know before even considering a borrow to invest strategy.
Firstly, in order for the interest on borrowed funds to be tax deductible, whether they come from an investment loan, home equity line of credit, or even a margin account, the borrowed funds must be used to earn either active business income or income from property such as a GIC, stock or even rental income. Secondly, an individual cannot deduct more loan interest than investment income produced in a year, but they can carry forward this difference to the following year. So, if you pay 4% in interest but only produced 2% of income only 2% is deductible in that year, but the remaining 2% can be carried forward to the next year. Lastly, interest costs must be payable during tax year in which they are being deducted and those interest costs must be reasonable. That means a loan taken at 30% when a bank rate is 4% may not be considered reasonable.
There are two common issues that arise when borrowing to invest stocks and mutual funds. With stocks the company must pay a dividend or at least have the prospect of paying dividends at some point, which would satisfy the income qualification noted above. In other words, if the company has stated it has no prospect of issuing dividends and the only source of return will be capital gains then the interest on the borrowed funds would not qualify for a deduction.
With a mutual fund, things get a bit trickier. Distributions can consist of a combination of dividends, foreign income, other income and return of capital (ROC). The ROC is where complications can arise, which is why it is very important to keep accurate tax records and consult a tax specialist when deducting interest expenses. The key piece on ROC is that unless this distribution is re-invested into another income producing investment, or that same mutual fund, the interest on the portion of the borrowed funds relating to those distributions can no longer be deducted.
A simple example would be: I borrow a $100 to invest in ABC fund and they give me a $10 distribution at year end. Instead of re-investing the $10 I buy some groceries with it. The distribution was classified as a return of capital. Because I did not re-invest the funds into a different, or the same investment that will, potentially, produce investment income, then only 90% of my loan interest would qualify for deduction in the following year. If it were classified as pure interest, then 100% of my loan interest would be deductible the following year.
Another common misconception is that if the borrowed funds are used to invest in monies in an RRSP or TFSA then it is deductible which is not true. Any borrowed funds used to invest in a registered plan will not be eligible for interest deduction. However, this does not necessarily mean that doing so is a bad idea. There are many cases where this strategy can prove to be quite fruitful in the long term due to the tax deferral, or even tax elimination these plans offer.
Mortgage interest is probably the most popular deduction. Mortgage interest is typically deductible if the loan is used to invest in income producing properties such as buying a condo and renting it out. This interest is deducted from the gross income that the property produces. However, if one were to convert the basement of their residential home into a rental unit and there was a mortgage on the property, then only the portion of the entire mortgage interest would be deductible. In this case it is the percentage of the rental space relative to the entire home.
Borrowing to invest is no easy strategy and also quite risky, but it can be a very effective strategy if done thoughtfully with a tax specialist. If you have any questions about borrowing to invest we would be happy to discuss further with you and your tax professional.