Interest Deductibility: Building Acquisitions

Marco Iampieri B.A., JD, M.B.A - with excerpts from EverGreen Explanatory Notes

At a time when interest rates are rising, a more common question from investors in real estate may concern interest deductibility.  When is the interest paid on a loan to finance a building or its construction, written off as an operating expense and when must it be capitalized? Most people are unaware of the latter option.

Let us separate this issue into two parts, assuming that there was a loan secured by an individual, business or other entity to finance the construction of the building.

The Basics – When is the interest deductible?    First, the entity obtaining the loan must use the loan to purchase the building and maintain the ability to documentarily support this represented fact. Whether the interest on the loan is deductible depends on its “direct and current use” of the money and the identification of an income-earning purpose.

For example,  whether the entity is intending to construct and own the building on account of capital, whether the entity is intending to construct and own the building on account of income (an adventure or concern in the nature of trade) or whether the entity is in the business of building construction and re-sale of building structures are all important factors.
If the entity is intending to construct and own the building on account of capital – as an investment -  then the borrowed money was not used for the purpose of earning income from a business or property, and therefore, would not be deductible pursuant to clause 20(1)(c)(i) of the ITA (this, in reference to property that is not a rental property).   For greater clarity, interest is a deductible expense against rental property income.
On the other hand, if the entity is intending to construct and own the building on account of income, then the borrowed money is used for the purpose of earning income from a business, and therefore, would be deductible pursuant to clause 20(1)(c)(i) of the ITA.

The Income Tax Act does not provide an exhaustive definition concerning which transactions constitute transactions that would give rise to income under subdivision C – taxable capital gains and allowable capital losses or under subdivision B – income or loss from a business or property.

Instead, one looks to jurisprudence, after gathering the facts, to determine whether the transaction has the indicia of a transaction or series of transactions on account of capital or on account of income.

A good reference is the EEN link Capital Gains and Losses – Overview and Adventure or Concerns in the Nature of Trade.  For jurisprudence, Happy Valley Farms Ltd. v. The Queen is a helpful case to read when learning the differences.