It’s actually a guest article by Kerry who is an accountant and currently articling with Meyers Norris Penny LLP in British Columbia.
As we all know, real estate is an investment whether for financial gains or for personal and family reasons, it’s still an investment. For some, the goal is to accumulate more than one property to earn an income from rental and to build a nest egg for retirement.
For those looking to purchase more than one property there are certain tax implications you need to be aware of.
The example given by Kerry is a client who has purchased a home in the past and has been able to pay off the mortgage well in advance, and the house value has sky-rocketed since. With this being said, the client is interesting in obtaining a newer, bigger house. However, the home has great sentimental value and the client wishes to hold on to it and rent it out.
Since the client has loads of equity in the old house, they head off to their mortgage broker to take out a mortgage on it to purchase the newer home. The client believes that the mortgage interest is now tax deductible because it’s on the rental property – a common thought for most.
When tax time rolls around, the clients accountant uncovers the big mistake that many make. The client is left with taxable rental income but non-deductible mortgage interest – a double whammy for the client.
Many question why the mortgage interest is non-deductible, but through the jigs and reels of it all, the proceeds from the refinance wasn’t used on the rental property, rather it is used to purchase the new, owner-occupied home.
Kerry provided the following information in the post. To simplify the subject, interest paid is generally deductible for tax purposes under the following two conditions:
1) The interest was paid or payable in the year in accordance with a legal obligation, and
2) The borrowed funds were used for the purpose of earning income from a business or property – the term “property” referring to interest income, dividends, rents and royalties but not capital gains.
The first point is rarely a problem because mortgages are set-up that way, but point number two is usually where the problem lies.
The CRA has a bulletin (IT-533 Interest Deductibility and Related Issues) which explains the interpretations of the deductibility of interest expense under various provisions of the Income Tax Act and provides several court examples to demonstrate a number of examples.
Basically, the main point the bulletin is getting at is that the “test to be applied is the direct use of the borrowed money”. However, there may be some exceptions to the indirect use.
The tax payer is responsible for determining what the funds were used for and reporting it correctly when completing your annual income taxes.
In the example given above, it’s clear that the client’s funds were to purchase a new owner-occupied, not to earn investment income. And as we all know, this interest isn’t tax deductible. Even though the rental property is the security, the use of the funds was not to earn an investment income.
How should an investor approach a situation such as this? Let’s take a look at client number two, we’ll call him Jack. He was in the same boat – current home mortgage free and lots of equity. But this is how he approached it:
1) On day one, Jack sold his current home (the “old home”) to his parents for fair market value. Jack’s parents paid for the purchase by issuing a promissory note to him. Always concerned about property transfer tax and other matters, Jack discussed this series of transactions with his lawyer who ensures all steps are properly documented;
2) On day two, Jack reacquired the “old home” from his parents by borrowing from the bank on the security of a mortgage. Jack plans to use the “old home” as a rental property;
3) Jack’s parents use the funds received to repay the promissory note they issued to him on day one, and
4) Jack then uses the funds received from his parents to purchase the new home.
Using the tracing principle applied by the CRA, it’s clear that the money borrowed from the lender was to purchase a rental property and therefore his interest is tax deductible.
The key takeaway point here is that when client are looking to purchase rental properties and they have a great deal of equity build up or reserve funds, it’s wise to speak with a professional before they make any move. The flow and use of the money is key when looking for tax deductibility and interest write-offs.
Again, many thanks to Million dollar Journey and Kerry for the insightful article.
*I am in no way, shape, or form a tax accountant. The intention of the article above is to bring to your attention the fact that there are tax implications related to purchasing, renting, and selling income-generating properties. Before you make any decisions it is strongly suggested that you talk to your tax accountant to ensure you have the appropriate plan in place.
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