Interest Deductibility Varies on Investment Activities

When can you claim the interest on investment loans? It’s a common question but the answer depends on the investment for which you are borrowing money. In order to claim the interest when you borrow money to invest, your loan must meet three criteria.

First, the interest costs must be payable during the taxation year in question. Secondly, those costs must be reasonable. Finally, (and most importantly), the borrowed money must be invested to earn business income (considered to be “active” in nature) or income from property (considered to be “passive” in nature).

The deduction for interest expenses is possible even if the underlying asset has not produced profits yet. There simply needs to be the potential to earn qualifying income like interest, dividends, rents or royalties.

If you dispose of an investment that you borrowed money to invest in and it has lost significant value, you may continue to write off the interest on the loan as if the underlying asset still existed. But the original asset must be traceable to the loan. If you dispose of the asset at a loss, or the asset no longer exists, you may continue to write off the interest costs so long as the proceeds were used to pay down the loan amount.

What expenses can’t be claimed? The government won’t let you deduct the interest on loans used to fund registered investments. So, you’re out of luck if you borrow money to invest in your workplace pension plan, an RRSP (Registered Retirement Savings Plan), a PRPP (Pooled Retirement Pension Plan), an RESP (Registered Education Savings Plan), or a RDSP (Registered Disability Savings Plan).

An exception is interest paid on loans that are used to top up past service contributions to a registered pension plan, such as your workplace defined benefit or defined contribution pension plan. These costs may be deducted as part of the RPP contribution.

Another red flag: don’t deduct interest on loans you took to acquire assets that produce tax-exempt income, such as your TFSA (Tax Free Savings Account) or your principal residence.

Similarly, you generally cannot claim interest on a loan used to make life insurance premium payments. But an exception exists if the policy is used as collateral for a business loan and the beneficiary is the lender. Check this out with a tax services specialist.

Finally, remember this important principle: Investments in assets that produce only capital gains are excluded from the definition of qualifying income for the purpose of interest deductibility. For example, if you acquire common shares from a company that has stated it will not issue dividends, you may not be able to deduct interest on any money you borrow to purchase those shares. That’s a trap for many investors in an audit. If, however, there is a possibility that dividends may be paid in the future, deductibility of the interest costs on the loan is legitimate.

The Bottom Line. If you have borrowed to invest, or paid investment counsel fees, chances are you’ll have a deduction against all other income as a carrying charge on Line 221. But to make it real, you have to make the loan traceable to income-producing investments.

Evelyn Jacks is President of Knowledge Bureau, Canada’s leading educator in the tax and financial services, and author of 52 books on family tax preparation and planning.

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