Tuesday, January 11, 2011

Deducting Mortgage Interest on Rental Properties

A colleague I’ll call Andy came up against a curious barrier to deducting mortgage interest on a rental property. Canada Revenue Agency (CRA) likes to see a straight line between the mortgage lump sum and the purchase of the property that will generate rental income. Unfortunately, it seems that Andy cannot easily draw a line that would satisfy CRA.

Andy owns a small home free and clear. He plans to move to a new larger home soon. He had hoped to rent out his old home to make some rental income. His plan had been to take out a mortgage on the old home and use this money to reduce the size of the mortgage on his new home. A side benefit Andy hoped for was using the interest on the mortgage on the old house once it becomes a rental property as a deduction against the rental income.

Unfortunately, CRA won’t allow this. From CRA’s point of view, the borrowed money wouldn’t be used to purchase an investment, but would be used to buy Andy’s new home. The following Q and A on page 12 of CRA’s Rental Income guide explains CRA’s thinking:
Q. I own and rent a semi-detached house. This year, I refinanced the property to increase the mortgage because I needed money for a down payment on my personal residence. Can I deduct the additional interest on the mortgage against my rental income?

A. No. You are making personal use of the funds you got from refinancing your rental property. As a result, you cannot deduct the additional interest when you calculate your net income or loss from your rental property.
If Andy were to go out and find some new rental property and buy it using borrowed money, then the mortgage interest on the rental property would be deductible against his rental income. This situation seems absurd. It’s hard to see any important difference between this scenario and what Andy hoped to do other than the fact that CRA treats them differently.

Perhaps CRA has the current rules in place to prevent clever schemes that skirt the intent of the rules and Andy is collateral damage. The end result is that Andy has to sell his current home and buy some different rental property if he wants to deduct mortgage interest. One solution suggested to Andy was to sell the old home to a family member or friend and then buy it back using a mortgage lump sum. I’d be worried that CRA wouldn’t accept the validity of these transactions.

If there are any readers who know of an easy way to solve Andy’s problems without entering into multiple expensive and pointless real estate transactions, I’m sure Andy would be happy to hear about it.

25 comments:

  1. It's unfortunate, but the CRA cares about what the loan is used to buy, not what it's secured against... even though in this case the leverage could be fairly said to apply to the rental property even when the money goes to buy a new principal residence.

    There are a few ways to set it up. The first is to sell off his (non-registered) investments, use those to buy the house, then take out a HELOC or mortgage (on either property) to buy eligible non-registered investments. i.e.: the Smith maneuver. The mortgage interest becomes deductable against the investment income rather than rental income, but still, deductible, and (depending on the size of his non-registered investment portfolio) can let him get back to his desired asset allocation and leverage...

    Another way takes a long time to swing the loan over to being deductible: basically open a HELOC and pay every expense for the rental property out of that, and put all the rental cheques against the mortgage for the PR. I don't think this method has been tested in the courts yet though.

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  2. I'm tempted to point out that an FAQ on the CRA website is not law and that someone should take the CRA to tax court over this. But that doesn't help your friend.

    I assume he could set up a corporation, use the cash to fund the corporation and have it buy the house from him. He should really work with an accountant in that case.

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  3. @Potato: If Andy has non-registered investments your first suggestion will work. The second suggestion looks interesting, but I'd definitely want an expert's opinion before trying it.

    @Robert: This is definitely a case of might makes right. Even if I were to fight CRA and win I'd still consider this to be a "life" loss. The corporation direction sounds interesting, but again I'd get an expert's opinion.

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  4. This really is an unfortunate situation. I recently experienced this myself. I own a duplex and about 1.5 years ago I lived in one side and rented out the other. I bought a new house to live in and took out a HELC on the one side of the duplex as a downpayment on the new place. But because the debt is not for an income producing asset I cannot deduct any of the interest from the HELC.

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  5. @Philbert: This must be a very common scenario. I can't see much reason why the interest shouldn't be deductible against rental income, but my opinion isn't going to have any influence.

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  6. 2nd option Potato describes is basically a 'cash dam' and is both tested and legal. Doesn't have to be a HELOC, but that would probably produce a lower rate.

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  7. @Sampson: Thanks for giving it a name. This will make it easier for Andy to ask a tax expert about it.

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  8. Were Andy to have a spouse and "sell" this property to his spouse with a promissary note at the prescribed rate assigned by the CRA a deemed disposition would occur and Andy's spouse could then claim all income generated and write off any interest applied. At the end of the day the benefits would not be spread between the couple, however the relief would be felt greater than the scneario of no one getting to claim a deduction. This works particularly well in cases where one spouse is in a considerably higher bracket....

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  9. Could one refinance the rental property (or soon to be rental property), and use the cash lump sum to invest in a 3-month non-registered short term GIC? This would be the investment with an expectation of a return.
    Then, when the GIC is cashed out in 3 months, use these funds toward the purchase of the new principal residence. The interest income on the GIC would be subject to taxation just like earned income, but would the mortgage interest on the rental property mortgage then be deductible against all future rental income?

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  10. @Elliot: I'm no tax expert, but my guess is that the mortgage interest would be deductible against the GIC interest only for as long as the GIC are held. Once the GICs are sold and the money used to buy a principal residence, I can't see why Andy would be allowed to deduct mortgage interest any more.

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  11. I'm running into this issue now. I fully own and live in a small home. Plan is to rent it out and refinance it to 20% so I can put money towards a new house to live in. I want to deduct interest expense. I'm still searching for a solution.

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    1. Hi Ben, I know you posted this a year ago, but just read your post and was wondering if you found a solution? I am in the same situation and do not understand why I could not use the money I invested and equity I acquired on my house, while it was my principal residence, to finance my new principal residence. My plan would be to refinance the rental property, leaving 20% in, and deducting the interests against the rental income. But not sure its allowed. Were you able to do it? I am about to seek advice from an accountant, but thought I would look on the net first.
      Thanks, Mylene

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  12. Hi
    my wife owns a rental property in Quebec.We would like to make it our principal residence Is there any reason I cannot or should not purchase it from her?
    How do I decide a reasonable purchase price.Is it a multiple of rental income or municipal valuation?

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  13. @Anonymous: It sounds like you're going in the opposite direction; turning a rental property into a principal residence. I'm not aware of any issues with this, but I'm no expert. As for choosing a fair market value, you would need to find out what is acceptable in Quebec.

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  14. My understanding is that the solution that CRA gave for this is found in CRA interpretation 2009-0352171E5 and involves the sale to a trusted family member etc. in exchange for a promissory note. The seller of the house then takes out a mortgage to repay the promissory note. The interest from the mortgage on the rental property is then tax deductible.

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  15. Thanks for the tip Anonymous - July 2012 (CRA interpretation 2009-0352171E5). I'm going to do a bit more research and possibly try this.

    Here's a link to the CRA letter:
    2009-0352171E5

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  16. I have a question regarding the "selling to a trusted family member and buying back" solution. Wouldn't that subject the person to provincial and potentially municipal land transfer taxes? In Toronto, the LTT can be as high as 15K for a $600K house. By doing the transaction twice, wouldn't you in essence lose $30k to the government in LTT?

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  17. The CRA letter says there no tax to be paid and no need to register land transfer. Anyone tried and can confirm?

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    1. @Anonymous: You'll have to point me to the letter you're talking about for me to try to help. There are definitely taxes involved with selling land if it's not considered your primary residence.

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  18. Thanks. This is exactly what I was looking for. I actually called CRA to ask about this and they basically said that this constitutes "tax planning" and they can't advise me on whether this can or cannot be done. Basically that I have to see an accountant. Still, I got the feeling based on other things they said that it's not allowed.

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  19. Hi, thanks for this post. I have a question, what if the "refinancing" on the rental property is done before I rent out my property? In that case will then the interest occurred on the mortgage deductible from rental income? Thanks!

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    1. @Lucas: I don't see why this would make a difference, but I'm no expert in these matters.

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    2. Hi Michael, I think it is quite "different". If you read the The following Q and A on page 12 of CRA’s Rental Income guide explains CRA’s thinking:
      Q. I own and rent a semi-detached house. This year, I refinanced the property to increase the mortgage because I needed money for a down payment on my personal residence. Can I deduct the additional interest on the mortgage against my rental income?

      A. No. You are making personal use of the funds you got from refinancing your rental property. As a result, you cannot deduct the additional interest when you calculate your net income or loss from your rental property.

      Carefully, I think the point here is refinancing your "rental property" and "additional interest", which means the "original interest" on your original mortgage on the "rental property" is still tax deductible. So I think if the "refiancing" was done when the property is still my primary resident, then that should not apply to the rule on "refinancing your rental property", and this seems more fair no matter if you buy a "new" rental property, or turn your primary resident into a rental property. However I will need to confirm this with an accountant. But at least this is what my TD financial advisor was telling me, of course she could be wrong ... In Canada many thing has to be figured out my ourselves ....

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    3. And I found the following here: http://www.cra-arc.gc.ca/E/pub/tp/it533/it533-e.html#P122_10420

      Refinancing transactions
      ¶ 41. Where borrowed money is used to repay existing borrowed money or an amount payable for property acquired, the new borrowed money is deemed to have been used for the purpose for which the money previously borrowed was used or to acquire the property upon which amounts were owing, as the case may be, by virtue of subsection 20(3).

      So it seems to me if I refiance the original mortgage I got to buy the property I was going to rent it out, then the new mortgage should be viewed as the same purpose as the previous one, which is buying the property.

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    4. @Lucas: It's not clear to me what your scenario is. When you say "refinance the original mortgage" do you mean make this mortgage larger? The situation from the original post is a fully paid-for property that the owner wishes to rent out. If you take out a fresh mortgage on such a property, CRA wants to know what you use the money for. Clearly you're not using it to buy the property, but for some other purpose. This appears to make the interest payments not tax-deductible against rental income.

      If you have an existing mortgage on a property and you got the mortgage originally to purchase the property, then it seems that you could rent out the property and get some tax relief from the interest. However, if at any time you dip into your equity (and grow the mortgage) to get money for some other purpose, the interest you pay on this portion of the mortgage appears not to be tax-deductible.

      In summary, my best guess based on my limited knowledge of these matters is that you are out of luck on any portion of the property that you have actually paid off, except for circumstances where you get another loan to pay off part of the mortgage.

      I think you should definitely find someone with more knowledge of these matters than I have to sort this out.

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