Mortgage Interest – It’s On The House!

It’s not often that a tax planner gets a freebee, so I’m just  giddy about this one! A recent tax court case and a related CRA opinion both give a detailed description of a tax plan and both say it’s OK!

Let’s say you have a home that is mortgage-free. You’ve decided to buy a new home, and convert your old home to rental property. If you simply move out and purchase a new residence and take a mortgage to finance it, the interest on that mortgage will not be tax-deductible, since the proceeds of the loan are used to purchase a residence. Meanwhile, your rental property (your former residence) is still mortgage-free – not the best result.

So, here’s the plan: First, sell your existing home at fair market value to someone you trust – let’s say it’s your brother. Your brother pays you with a promissory note. There is no income tax on the sale, because the property was your principal residence.

Next, Buy back the old home from your brother. To finance this purchase, you take out a mortgage on this home. Now that the home is to be used as a rental property, the future interest payments will be tax-deductible.

The mortgage proceeds go to your brother as consideration for the sale of the property back to you. He then uses these funds to pay off the promissory note he issued to you when he bought the old home.

You now have the funds from the promissory note in your hands. You can use this money to buy yourself a new home.

The Tax Court of Canada, in the case of Sherle v. The Queen, actually volunteered this plan as a way to make mortgage interest deductible in the above scenario, and the CRA approved it in a recent technical interpretation.

There you go — it’s on the house!

6 thoughts on “Mortgage Interest – It’s On The House!

  1. I’m definitely not a tax expert, but, wouldn’t the interest received from the brother on the promissory note be included in property income? Seeing as the rate on the note would have to approximate fair value, it seems that this would cancel out the benefit of the mortgage interest deduction. The brother would be able to deduct the interest on the promissory note, but wouldn’t he have to establish some reasonable expectation of profit?

    • Stefano:

      The promissory note gets repaid immediately. There is no interest received on it. The only debt that exists when all is said and done is the mortgage used to repurchase the property. Since that is now a rental property, the mortgage interest is deductible.

  2. Just a couple questions on this strategy. What is used for security to acquire the mortgage if you have sold the property to your brother (in this scenario)? Would this not involve considerable closing costs to transfer the property from you to your brother and then back again?

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