Is investment loan interest always a tax deduction?

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by Edward Robertson

[UPDATE: 23 Jun 2018. After discussions with my accountant as to what deductions can actually be claimed, and remembering Garth Turner's pronouncement on the subject, the rules outlined in this blog post are decidedly the conservative, by-the-book version. Turner said: "Some advisors will tell you investment loans are only tax-deductible if the money is used to earn actual income (interest, dividends) as opposed to buying stuff that goes up in value (capital gains). In the real world, that’s hokum. The CRA will never enforce this arcane tax code verbiage for average investors." [3] ]

Investors in private market assets will likely contemplate at some point borrowing to invest. I thought it worthwhile to summarize rules around using investment loan interest as a tax deduction, and comment with respect to private market products.

Where other factors are equal, the issue of tax deductible loan interest is non-trivial. For example, consider a $100,000 loan from, say, a Home Equity Line of Credit at 3.2% interest, and assume a 32.79% Marginal Tax Rate. Over one year, a successfully claimed deduction gives a tax savings of $1,049.28  [$100,000 x .032 x .3279]. But investigate, and consider the following rules, before using leverage to invest.

[DISCLAIMER: Do not make any decisions based on the information in this post, which is to be considered only a starting point for discussion between the reader and his/her expert advisors. No claim is made to an exhaustive or flawless treatment of the subject, which is complex, as can be individual tax situations. Further, the rules are constantly changing. My sources are listed at the end of the article.]

Rules

1. You must receive income, and of the right kind.  Investments must earn interest, dividends, rent, or royalties in order to make the loan interest eligible for deduction. Alternatively, there must be a reasonable expectation of future dividends; further, the dividends cannot have been re-invested.

2. Capital Gains do not qualify. “If an investment will never earn anything except capital gains, then the interest expense is not deductible.” [1]

These are already important considerations, as many exempt market and private market investments targeted to accredited investors are purely “equity plays”, meant to pay a capital gain at the end of the term, with no provisions whatsoever to pay dividends along the way.

3. Restricted investment account types and targets:
    RRSPs, RESPs, and TFSAs do not qualify. (There is an exception if the investment was purchased in a non-registered account, the loan is completely paid off, and the asset is transferred to an RRSP.)
    Loans used to purchase a life insurance policy do not qualify.

Many exempt market issuers adhere to requirements to make their products eligible for registered accounts, in order to make them more attractive to the average retail investor. Of course, using an RRSP or a TFSA confers tax advantage, yet for the loan interest to be tax deductible, the investments must be held in a non-registered account.

Advanced strategies are possible using private company “participating” whole life insurance policies and their associated cash value accounts. Yet apparently one cannot borrow to fund such a product and expect to write off the interest.

4. ROC distributions disqualify the loan interest deduction. ”Interest paid on money borrowed to invest in a mutual fund offering return-on-capital (ROC) distributions may not be tax deductible.” [2]

To the investor who borrows, this will reduce the appeal of many exempt market products whose distributions are structured to be return of capital. The attraction of ROC distributions (usually monthly or quarterly) is that they are received tax-free. Although the adjusted cost base will be eroded and thus increase the eventual capital gain upon sale of the asset, this arrangement generally represents an overall tax efficiency. We simply point out that if you use leverage to acquire such a product, you cannot deduct the interest.

5. Record-keeping. Use a separate investment account and do not withdraw from it for personal expense or other unrelated purposes – there must be no co-mingling of funds. The paper trail to the actual investments must be clear.

6. There was a federal Finance department rule saying that the dividend earnings had to exceed the loan interest in order for the deduction to be allowed. “Where the interest expense exceeds the income from the investment, the interest expense will normally still be tax deductible.” [1] This is definitely a point to follow up with your tax advisor; I draw attention again to the disclaimer above.
 

Conclusion
We have seen that exempt market products will often have a tax advantage built in, whether it is eligibility for registered accounts (RRSP, TFSA, RESP) or return of capital (ROC) distributions. Of course, there are private investments that simply distribute interest payments. When selecting an investment where significant leverage is used, the question of tax deductible loan interest could be a deciding factor.

Sources
[1] Taxtips.ca
http://www.taxtips.ca/personaltax/investing/interestexpense.htm

[2] Advisor.ca
http://www.advisor.ca/my-practice/investment-loans-and-interest-deductibility-be-mindful-of-roc-99887

[3] Garth Turner: The Greater Fool - "Getting Soaked"
http://www.greaterfool.ca/2017/11/23/getting-soaked/

Keywords
borrow to invest, investment strategy, tax strategy, HELOC, RRSP, TFSA, investment loan, tax deductible