What’s Your Tax Issue? Mortgage Refinancing

The Tax Issue:

Our rental property is coming up for mortgage renewal.  Can we take equity out of the rental to pay down on our principal residence?  Obviously then, the mortgage on the rental has increased and the interest is being written off.  Can we do this?

The Answer:

Well, since this is the second time this week I’ve been asked the same question, here’s the answer: NO!

Perhaps I should elaborate.

Under Canadian tax law, interest on borrowed money is deductible only under certain specific conditions. For the sake of bandwidth, I will only mention the most important:

The borrowed money must be used for the purpose of earning income from a business or property.

The emphasis on the word used is intentional. The Supreme Court of Canada, many years ago, laid down the rule that it is the use of the borrowed funds that we look to to determine whether this condition is met. To be more specific, it the direct use made of the borrowed funds. This is a technicality that has both helped and hindered the CRA over the years.

In your case, for example, even though you have dutifully paid down the mortgage on the rental property and now own equity in it, refinancing it is simply borrowing money, using your equity in the rental property as collateral. It is not the collateral that is important, but the direct use of the borrowed funds. Therefore, if you use the borrowed money, as you intend, to pay down you personal mortgage, this will be viewed as money borrowed for personal use, and the interest would not be deductible.

One often recommended strategy, taking advantage of the “direct use” rule, would be to use funds that you currently have invested in savings, such as stocks and bonds to pay down your personal mortgage. Then, refinance the rental property, and use the borrowed funds to repurchase your income-earning investments.

Alternatively, if you remortgaged your rental property and purchased a second rental property, or invested in some other income-earning vehicle, then the interest would be deductible.

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!