What Makes Interest on Investment Loans Tax Deductible?
1. Interest Must Be Paid or Payable
To qualify for a deduction, there must be a legal obligation to pay the interest. This ensures the lender can enforce repayment of the loan principal and interest.
- For Individuals (Cash Method): Deduct interest in the year it is paid.
- For Businesses (Accrual Method): Deduct interest in the year it becomes payable, even if not yet paid.
đź’ˇ Pro Tip: Compound interest is only deductible when actually paid. Plan repayment schedules accordingly to maximize deductions.
2. Interest Costs Must Be Reasonable
Interest costs must reflect market conditions and should be comparable to rates offered to borrowers with similar credit risks. The Canada Revenue Agency (CRA) can deny deductions if the interest is deemed excessive.
Example: Avoid Overcharging Yourself
If you borrow funds from your own corporation at an inflated interest rate, the CRA may disallow the deduction. Always use market-aligned interest rates to ensure compliance.
3. Interest Must Be Incurred to Earn Income
The loan must be used for generating income, such as dividends or interest. Capital gains alone do not qualify as income for deductibility purposes. However, if your investment aims to produce income in addition to capital growth, you may still deduct the interest.
Example: Borrowing to Invest in Dividend Stocks
If you borrow $100,000 to purchase dividend-paying stocks, the expectation of earning dividends makes the interest deductible, even if the stock price appreciates.
Common Deductibility Limitations to Watch For
Non-Deductible Uses of Borrowed Funds
Interest is not deductible if funds are used to:
- Earn exempt income.
- Purchase life insurance policies.
- Contribute to registered plans like RRSPs, TFSAs, or RESPs.
Exception: Segregated Funds
Interest on borrowed money used to purchase non-registered segregated fund contracts is deductible, as outlined in Subsection 20(2.2) of the Income Tax Act.
Advanced Strategies for Maximizing Interest Deductibility
1. Handling Return of Capital
When investments distribute a return of capital that is used for personal purposes, the CRA considers this a reduction in the loan’s income-generating purpose. Adjust your deductions proportionately.
Practical Advice
Reinvest distributions from your investments to maintain the link between the loan and income generation, preserving your interest deductibility.
2. Deducting Interest on Disappearing Investments
If your borrowed money no longer generates income because the investment is sold or loses value, you may still deduct the interest. Section 20.1 of the Income Tax Act allows this if the proceeds are applied to reduce the loan.
Example: Deducting Interest After a Stock Sale
Suppose you borrowed $50,000 to purchase shares that are sold for $30,000. You can still deduct interest on the remaining $20,000 loan balance if the proceeds were used to reduce the debt.
3. Importance of Tracing Funds
Accurate record-keeping is critical for maintaining interest deductibility. Borrowers must trace the use of borrowed funds to eligible purposes.
Tips for Clear Tracing:
- Use separate accounts or dedicated credit lines for investment loans.
- Avoid commingling borrowed funds with other sources of cash to ensure clarity.
Key Income Tax Act Provisions Simplified
Paragraph 20(1)(c): Basic Criteria
Defines the fundamental requirements for deducting interest expenses, focusing on reasonableness and purpose.
Subsection 248(1): Exempt Income
Clarifies that interest incurred to earn exempt income cannot be deducted.
Subsection 20(2.2): Segregated Funds
Allows interest deductions for non-registered segregated fund contracts.
Section 20.1: Disappearing Income Sources
Permits continued deduction of interest even if the income source disappears, provided proceeds reduce the loan balance.
FAQs: Your Top Investment Loan Questions Answered
Can I Deduct Interest on Loans Used for Mutual Funds?
Yes, provided the mutual funds generate income like dividends or interest. Ensure there is a reasonable expectation of earning income at the time of purchase.
What Happens If My Investment Generates a Loss?
You can still deduct interest in a year where investment income is less than the borrowing costs. The deduction remains valid as long as the purpose of earning income is maintained.
How Do I Deduct Interest on Commingled Funds?
Keep detailed records and use a constant prorated method to allocate interest deductions between eligible and ineligible uses. Using dedicated accounts simplifies this process.
Take Control of Your Investment Strategy
The rules for deducting interest on investment loans offer significant opportunities to reduce your tax burden—but only if you navigate them correctly. By meeting the criteria outlined in the Income Tax Act (Canada) and maintaining meticulous records, you can maximize your deductions and achieve your financial goals. Consult with a Thorough Wealth Consultant today to ensure your investment loan strategy is optimized for tax efficiency.