You have a paid off or nearly-paid-off home that isn’t quite meeting your family’s needs. The back yard is cramped, there isn’t a room for the baby on the way and a bigger garage would be nice. Rather than selling your current home to upgrade, why not borrow against your current home to buy your new home and rent out your old place? You have heard that the mortgage on a rental property is tax-deductible. That should help lower your costs, right?
Enough clients have asked us this question that we needed to clarify:
In the above scenario, you cannot write off the mortgage interest.
In many cases in Canada, when an investor borrows money to invest and generate taxable income, they can deduct the interest from their income for tax purposes. Say you borrowed money to buy equipment to start a business or to invest in a portfolio which pays some interest and dividends. Both activities are expected to generate taxable income. If you borrowed $10,000 at a rate of 5% on January 1st, at the end of the year you would have paid $500 in interest. When you file your tax return you get to deduct $500 from your income. This will either lower the amount of tax you owe or generate a refund equal to the amount of the deduction times your tax rate.
If your tax rate is 30%, that means you reduce your tax bill by $500 times 30% or $150. The net, after tax cost of interest was only $350 or 3.5% ($350/$10,000) after you include the tax refund. This is one of the reasons why debt to fund investments is often called “good debt”. The after-tax cost of the debt is lower than if it was used to buy things for personal use and in theory, the what you buy should grow faster or pay more than the interest you pay over time (otherwise why would you borrow the money?).
A rental property is also an asset which is expected to generate taxable income. That means when you borrow funds to purchase a rental property, in addition to property taxes and maintenance costs, you can write of the interest on your loan. This is the case whether you take a home equity line of credit against your home or use a traditional mortgage.
If you have a new home, a loan, and a rental in the initial scenario, then why can’t you write off the interest?
In the initial scenario you are borrowing to buy something you plan to personally use and consume, your family home, not something that will generate additional income. It doesn’t matter that you are borrowing to keep a rental property, what matters is what the funds from the debt purchase.
Even though the debt is secured by a rental, it wasn’t used to buy the rental. This means that you cannot write off the interest. When you look at the interest cost, you must consider the full amount as there will not be a deduction.
There is an expression “don’t let the tail wag the dog”. What this means is don’t let something small, like the ability to write off interest, dictate how you structure the big thing, the dog, how you structure your investments. The examples below are to illustrate how to have debt with interest you can write off while maintaining the same risk level and balance sheet.
There are several downsides here. You may be triggering gains in your portfolio prematurely in order to sell and buy the home. If you are triggering losses, you cannot purchase the same investment within 30 days otherwise the loss will be denied. It is also more difficult to get approved to borrow to purchase a portfolio than it would be to purchase real estate – this is the nature of the Canadian banking system.
This situation is common enough it warrants an explicit statement: when you borrow to purchase your personal home, the interest is not tax-deductible, regardless of whether you use an investment as collateral or not. There are ways to restructure assets to improve tax-efficiency but often downsides to do so as well. You should never accept a sub-optimal investment strategy in pursuit of a tax advantage.
