Planning for interest expense

When money is borrowed for business or investment purposes, the interest is normally deductible for income tax purposes. If the borrowed funds are used to finance personal expenditures, such as mortgages, car loans or RRSP contributions, the interest is not deductible. Ideally, families would like to have their debt finance items that are deductible for tax purposes. However, most families have investments with no debt attached and outstanding personal loans, such as mortgages and car loans. There is a tax planning strategy known as the ‘interest shuffle’, which was legitimized by the Supreme Court decisions in the Singleton case. This tactic allows taxpayers to transfer debt from non-deductible sources to investments, resulting in tax-deductible interest expense.

Assume the following facts:

• A taxpayer owns a home that has a $75,000 mortgage
• The taxpayer also owns $75,000 of stock and debt was not used to purchase the shares

The interest on the mortgage is not deductible.

The interest rate shuffle allows the taxpayer to transfer the debt from the personal assets to the investments and attain a tax deduction.

In order to implement this strategy, the taxpayer must sell the stock and use the proceeds to pay off the mortgage. The taxpayer would then approach a financial institution and borrow $75,000 to repurchase the investments. The individual may choose to purchase investments other than those that were previously owned. If there is a capital loss on the disposition of the shares and the investor decides to repurchase the same shares, he or she must wait 30 days before reacquiring the shares or the superficial loss rules will deny any capital loss.

The result is the debt is attached to the investments and not the mortgage. Thus the interest is now deductible for tax purposes. This strategy is not always successful, especially if it is not properly documented. The tax department could attempt to apply the general anti-avoidance rule, which gives the Canada Revenue Agency the power to set aside a transaction where there is no business purpose for the transaction, i.e. the transaction was undertaken for tax purposes and no other reason. To implement a tax planning strategy that maximizes your potential interest deduction, consider the following steps:

• Manage your borrowing so that wherever possible, debt is used to finance investments and savings are used to purchase personal assets
• All other factors being equal, pay off personal loans, before eliminating debt on investment loans, and
• If consideration is being given to transferring debt from personal assets to investments, ensure the documentation is perfect.