Line of credit a taxing matter
The ability to write off interest paid on an investment loan is critical to the financial success of many leverage strategies employed by investors. What's more, the basis of such interest deductibility is firmly rooted in the Income Tax Act.
The Act states that if funds are borrowed for the purpose of earning business or investment income, the interest paid on such funds is tax deductible.
However, some recent comments by the Canada Revenue Agency have called into question exactly how much interest is deductible when it comes to the matter of partially paying down a line of credit.
Let's assume Doug has a secured line of credit that he took out last year to renovate his home. The balance owing on Jan. 1, 2008, was $60,000. Since the interest paid on the line of credit is not deductible, the loan is often referred to as "ineligible."
This month, Doug decides to borrow money to begin a leveraged investment program and thus increases his line of credit by $40,000, bringing the new balance to $100,000. The $40,000 is invested in a broad range of securities for the purpose of earning income and thus is considered eligible for interest deductibility.
As a result, Doug should be able to deduct approximately 40% of the interest paid.
Now let's assume that on Feb. 1, 2008, Doug receives his 2007 bonus and decides to pay down his line of credit by $20,000. The new balance owing on the line of credit at Feb. 1 is now $80,000. The full $40,000 remains invested in income-producing securities.
The question is how much of the February, 2008, interest paid would be tax deductible? While you might conclude 50% of the interest would be tax deductible since $40,000 of the $80,000 outstanding balance remains invested for the purpose of earning income, the CRA disagrees. In its view, when the principal portion of a line of credit is repaid, such repayment reduces both the portions of the line of credit used for eligible and ineligible purposes. In other words, Doug cannot choose to allocate the $20,000 payment made on his line of credit to the ineligible use. Rather, any repayments are considered to be made pro rata. Since Doug's $100,000 line of credit was 60% ineligible and 40% eligible, the $20,000 payment made on Feb. 1 must be allocated accordingly.
Doug should probably have established a separate line of credit in which the borrowings are used exclusively for investment purposes. That way, 100% of the interest paid would have been tax deductible.