Rental Property Investment—Interest Deductibility
You have purchased [plan to purchase] a rental property that will be partially financed with a mortgage. Also, you have a mortgage balance remaining on your personal residence. You wanted to know how much interest you will be able to deduct from your rental property income.
Generally, for interest to be deductible in respect of a loan, the borrowed money must be used for the purpose of earning income from a business or property (for this purpose, “income” means gross as opposed to net income). Thus, the use of the borrowed funds must be established and the purpose of that use must be to earn income from a business or property. The relevant use is the current use and not the original use of borrowed money. Interest arising on borrowed money used to purchase a principal residence will generally not qualify for a deduction since the borrowed money will not be used for the purpose of earning income from a business or property. On the other hand, interest arising on borrowed money used to purchase a rental property for the purposes of earning rental income will generally be deductible.
An individual may borrow money under a line of credit that is secured by the individual’s principal residence. Whether interest on that borrowed money is deductible is a mixed question of fact and law. If borrowed funds on a line of credit secured by a principal residence are used to pay for personal items such as vacations or personal residence home improvements, the portion of interest expense on the line of credit relating to those purchases will not be deductible for income tax purposes. If borrowed funds on a line of credit secured by a principal residence are used to pay for outlays or expenses related to a rental property, the portion of interest on the line of credit relating to those purchases will generally be deductible. The tracing/linking of borrowed money to an eligible use where a single borrowing account such as a line of credit is used for both eligible and non-eligible purposes can be complex and the onus is on the taxpayer to trace/link borrowed funds to an eligible use.
A basic strategy to maximize deductible interest would be to pay your personal expenses (including mortgage payments on your personal home) directly from your rental income, and to borrow any funds needed to cover rental operation expenses since interest on such borrowings will generally be deductible. To implement this technique, you will need separate bank accounts; one for depositing rental income (the Rental Income Account), and a second with a line of credit secured by your principal residence (the LOC Account). Cash damming will allow borrowed funds from the LOC Account to be readily traced to a specific eligible use for interest deductibility purposes.
A second strategy to consider would involve paying off the current mortgage balance on your principal residence, and re-borrowing new funds to invest in [(or purchase)] the rental property. For example, if you have an investment portfolio in a non-registered account, you could sell some or all of the securities to repay the mortgage on your principal residence (alternatively, funds could be withdrawn tax-free from a TFSA). As soon as the next day, you could borrow the same amount of funds to pay for rental property related expenditures.
Example 1 :
Jack has an existing $200,000 mortgage on his personal residence, $50,000 in a TFSA, and a $350,000 investment portfolio in a non-registered account. Jack withdraws $50,000 from the TFSA, and sells $150,000 worth of securities (Jack selects securities with low or no accrued gains to sell to avoid paying taxes on the dispositions—if Jack sells shares with a loss to offset gains but wishes to still own the disposed of shares, he must wait thirty days before repurchasing the shares or the use of the loss will not be permitted). Jack utilizes the $200,000 to repay the mortgage balance on his personal residence. The following day, Jack borrows $200,000 (secured by his principal residence) and uses the funds to renovate an income earning rental property. Interest paid on this new loan is deductible in computing the income/(loss) from the rental operation.
Example 2 :
Assume the same facts as Example 1 except that Jack does not have an investment portfolio or a TFSA account balance. Instead, Jack utilizes the equity he has in his principal residence by applying for a line of credit (LOC) secured by the home. The borrowed funds, which are deposited in a new account, are used to renovate/purchase an income earning rental property. Jack incurs annual losses on his rental operation approximately equal to the annual LOC interest charges. Jack deducts the losses from his rental property against his employment income, generating a tax refund. Each year, the tax refund attributable to the rental loss is used to pay down the mortgage on Jack’s principal residence (i.e. the mortgage in respect of which interest incurred is non-deductible—note that most mortgages allow for a percentage of the principal to be repaid early each year without penalty). As the principal residence mortgage is paid down, the available LOC automatically increases based on the terms of the LOC negotiated with the bank (this strategy works best when the LOC interest rate is similar to the interest rate on the principal residence mortgage and the LOC has a re-advanceable feature). All rental operation related expenses are paid for using funds borrowed from the LOC (i.e. the LOC in respect of which interest incurred is deductible), and additional borrowed funds are used to finance the rental operation. Rental receipts are deposited in a third account which is used to pay for personal expenses. After a number of years, the mortgage on the principal residence is fully repaid, and interest on the remaining amount of debt Jack owes (i.e. the LOC balance) is deductible in computing income from the rental operation.
If you are interested in any of the above mentioned strategies, before you contact your bank, we should discuss/model the various options and assess your credit availability.
For more information, please contact email@example.com or 1 844-GYTD-CPA