Tracing Rules for Deductibility of Interest

You recently enquired about the interest charges you paid throughout the year and the deductibility of this interest on your tax return. There are many rules regarding interest deductibility and these rules vary depending on whether the loan proceeds were used for personal, business or investment purposes.

Personal interest is not deductible on your tax return. This would commonly include interest such as automobile loan interest and mortgage interest for your home if there is no business usage of these assets. Reasonable interest charges on loans used for business and investment purposes can be deducted from income. However, the onus is on you to trace the loan proceeds to the business or investment use.

Tracing requires you to link the borrowed money to its eligible use. For example, you may receive a loan to pay for business expenses. The proceeds of this loan should be transferred directly into your business account that you only use to pay for business expenses. By doing so, you can directly link the proceeds to your business activities, and you can deduct the total interest charges from your business income. Similarly, you may receive a loan to purchase marketable securities. If the total loan proceeds are transferred directly into your broker account, the total interest charges can be deducted from investment income.

Tracing can be more difficult when the loan proceeds are used for a mixed use. For example, you may receive a bank loan of which 60% is used for investment purposes and 40% is used for personal purposes.

In this situation, only 60% of the interest charges are deductible. As the loan is repaid, each principal repayment is allocated on the same basis: 60% will be allocated to the investment portion of the loan and 40% to the personal portion.

Tracing can also be complicated due to refinancing a loan and may require the interest charges to be pro-rated. For example, you may receive a mortgage on your home at the time of the purchase. The interest charges are not deductible as a result. With $400,000 remaining on your mortgage, you refinance the loan for proceeds of $500,000. The extra $100,000 is used to pay a down payment on a rental property. In this scenario, 80% of the mortgage interest is not deductible and 20% may be deducted against the rental income. Same as the previous example, repayments will be pro-rated accordingly.

Refinancing can also provide an opportunity to convert non-deductible interest to deductible interest. For example, you may owe $500,000 on the mortgage for your home and have a $500,000 non-registered investment account. You can dispose of the securities in your account and repay the mortgage in full. You can then take out a new $500,000 mortgage against your home and deposit the proceeds back into your investment account. The loan proceeds can now be directly linked to your investment income and the interest can be deducted on your tax return.

It can be very difficult to directly link interest charges to a business or investment purpose when loan and non-loan funds are combined in one account which has multiple uses. It is always advisable to use separate accounts for personal, business and investment purposes. Depositing the proceeds of the loan into its own account is your best option for tracing the use of the funds.

Interest may be deductible in certain situations, and you must keep proper records to support its deductibility. This should be planned for at the time the proceeds are received. You may be able to refinance certain loans to maximize your interest deductibility.

For more information, please contact info@gytdcpa.com or 1 844-GYTD-CPA

GYTDCPA.com-2021 Tracing Rules for Deductibility of Interest

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