The ability --or lack thereof -- to write off mortgage interest is a near-obsession for many debt-strapped Canadians who gaze enviously at our neighbours to the south, where such interest is tax deductible.
In Canada, mortgage interest is generally only deductible if the loan was used to finance an income-producing property. The Canada Revenue Agency continues to take a strong position on a direct link between mortgage proceeds to the income-producing property.
This is evidenced by the CRA's recent response to a fairly common situation: Joey owns Property A, which he currently lives in as his principal residence. He decides to purchase a second home, Property B, which he intends to rent out. He finances the purchase of this home with a mortgage.
A couple of months later, Joey finds that he is unable to rent out Property B and decides to move into that home and rent out Property A instead. The CRA was asked what effect such a move would have on the interest deductibility of the mortgage used to finance Property B.
Not surprisingly, the CRA, referring to a 20-year-old Supreme Court of Canada decision, stated that it's the "current use made of the borrowed money … rather than the original use of the money which must be considered" to determine whether interest paid on the borrowed money is tax deductible.
Since Joey is now living in Property B, the current use of the borrowed money can no longer be linked directly to an income-producing use, and thus interest on the mortgage would no longer be tax deductible.
But the CRA's position on direct tracing of mortgage interest deductibility doesn't always hold up in court, as evidenced by a tax case decided last month.
Ronald and Marie Heaps purchased a large lot on Vancouver Island in 1994 for $630,000, paying for it with $350,000 in cash from the sale of their former principal residence and taking a mortgage for the balance. The lot contained a residence on the corner of the property that they intended to occupy. It was their intention to subdivide the rest of the property for resale, which they ultimately did.
During the years prior to resale, however, the Heaps deducted 100% of the mortgage interest paid on the basis that the mortgage was "used exclusively to finance the portion of the property that was subdivided and sold."
The CRA objected, arguing, as above, that "it is the direct use of the borrowed funds that determines the deductibility of the interest." In other words, since the funds were used to finance the purchase of the entire property, the loan interest should be prorated between the personal and subdivided portions, and only the subdivided portion of the mortgage interest should be tax deductible.
Fortunately for the Heaps, the judge ruled that since the Heaps paid for a reasonable portion of the property in cash, their intention was to use the mortgage funds exclusively to finance the subdivided portion of the property and thus the interest was found to be entirely tax deductible.