When is Interest Deductible?

There are two types of interest in this tax world of ours - deductible and non-deductible. Obviously you want as much interest payable to be deductible.

Generally, interest on money borrowed for the purpose of earning income from a business or property is deductible.

So, too, is interest on the amount you pay for property you acquire to either gain or produce income from the property itself or from a business.

Interest on consumer loans, personal-use credit cards and car loans or home mortgages, well - they are ours to pay out of after-tax dollars.

With a little financial planning and refinancing, you might be able to turn some of you non-deductible interest into the more favoured kind.

The Supreme Court of Canada agreed with an individual's right to plan financial matters so he or she can take advantage of favoured tax treatment on interest expenses [2001 DTC 5533].

For instance, the interest on a $100,000 mortgage on your home is not deductible. But, if you have $100,000 invested in your own business or corporation, you can take the following approach:

First, withdraw the funds from the business.

Second, pay down the mortgage on your house.

Then, borrow $100,000 from the bank using your house as collateral, and

Finally, reinvest the $100,000 back into your business.

The interest on the $100,000 is now deductible, because it is being used to finance and generate income in the business rather than finance your house.

However, in a more recent Supreme Court of Canada decision [2009 DTC 5015], a taxpayer tried to duplicate the above only they generated interest expense in a non-arm’s length sale of a family corporation shares between spouses. 

The Supreme Court judges felt there was a misuse of the non-arm’s length relationship (the interest attribution rules) in generating the interest expense and applying it towards dividend income. In this case the taxpayers were unsuccessful at claiming interest expense.

Consult your tax advisor before entering into a series of transactions which may leave you no better off than when you started.