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INVESTING TAX PLANNING Tax traps to avoid when you borrow for investments Pitfall could hurt interest deduction

October 25, 1997 | The Globe and Mail B.20. |Tim Cestnick.

In [STEVE]'s case, he had borrowed $50,000 to invest. The investment increased in value to $80,000 over time, and Steve sold $20,000 of those investments to use for personal expenses. The $20,000 in proceeds represented 25 per cent of Steve's investments (25 per cent of $80,000 is $20,000).

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Tax traps to avoid when you borrow for investments Pitfall could hurt interest deduction

INVESTING TAX PLANNING

Tax traps to avoid when you borrow for investments Pitfall could hurt interest deduction



Special to The Globe and Mail

STEVE has a bad habit of borrowing money. In university, we used to avoid him like the plague because he'd always be asking to borrow five or ten bucks.

Steve was dating Pamela, and rumour has it that one night he said to her: "Pamela, you know I've always relied on you -- er, er -- can you -- ah -- Pamela, will you marry me?"

"Oh-h-h," Pamela sighed with apparent relief. "You scared me for a second. I thought you wanted to borrow some more money." Today, Steve and Pamela are happily married.

Steve called me last week. He left a message that he wanted to talk about borrowing money. I was a little worried.

Turns out that, oddly enough, he wasn't looking to borrow from me. Rather, he had a problem with Revenue Canada.

You see, Steve had borrowed money from his bank for investment purposes. He deducted the interest costs on his tax return, but the taxman disallowed a good portion of his interest deduction. He discovered a pitfall that many Canadians are not aware of. Let's take a look at interest deductibility, and the pitfall to avoid.

The deduction

The taxman has been kind enough to allow Canadians to claim a deduction for interest costs incurred in certain situations. If you are using the borrowed money to earn business income, you'll be entitled to a deduction for interest costs.

Second, if you are using the borrowed money to earn income from property, which normally includes interest, dividends, royalties and rents, you'll be afforded an interest deduction as well.

Note that I haven't included capital gains in this list of income from property. The fact is, however, that many investments that offer the potential for capital gains also have the potential to pay dividends, royalties, rents or interest. The result? Interest costs are generally deductible on funds borrowed for these types of investments.

The problem

Steve's problem is not uncommon. I have met more Canadians in the past six months who have borrowed to invest than I have in a number of prior years. This phenomenon is partly attributable to the many financial advisers who are recommending to their clients that they borrow to invest -- after all, money is cheap today with interest rates as low as they are.

I'm not going to debate the pros and cons of borrowing to invest because everyone's situation is different: It's prudent for some and bad for others.

Steve's problem is this: He borrowed to invest and watched his investments grow over time, then liquidated some of his investments to use the money for personal expenses such as taking a vacation, home renovations, and even paying off credit card debt.

Presto -- Steve's interest deduction was reduced. You see, when determining whether interest is deductible, the taxman looks at the current use of the borrowed funds, and not the original use.

When investment assets are acquired with borrowed funds, and a portion of those investments is then disposed of, you might also say goodbye to a portion of your interest deduction.

In Steve's case, he had borrowed $50,000 to invest. The investment increased in value to $80,000 over time, and Steve sold $20,000 of those investments to use for personal expenses. The $20,000 in proceeds represented 25 per cent of Steve's investments (25 per cent of $80,000 is $20,000).

The result? Twenty-five per cent of the interest on Steve's original loan is no longer deductible. Ouch. He hadn't bargained for that.

If you're one of the thousands of Canadians who has, for example, borrowed money to set up a systematic withdrawal plan with your favourite mutual fund company, this lesson is important.

Be careful how you use your withdrawals. If you're using the funds exclusively for personal expenses, you'll be in the same boat as Steve.

The solution

Wondering how to beat this tax trap? Here are four ways to help yourself.

1. Avoid redemptions or liquidation of your investments. It may sound simplistic, but leaving your investments to grow without touching them will preserve your interest deduction. And if you're going to sell, be sure to reinvest in another income-producing asset to continue deducting your interest fully.

2. Access the income from your investments only. You won't hurt your interest deduction if you withdraw the income (but not capital gains) on your investments before this income is reinvested.

However, if the money is reinvested in more units of the same fund, the taxman won't distinguish between those new units and the original units purchased with the borrowed funds.

If you redeem units after the reinvestment, you'll hurt your interest deduction. Again, capital gains are not considered to be income from property, so cashing in to take some of these gains will create an interest deductibility problem.

3. Use money from other sources to pay off your debt. Even if you redeem or liquidate some of your investments to partially pay down the very loan you took to make the investments, a portion of the interest on the remaining loan will not be deductible. Why? Because the funds withdrawn were not reinvested in income-producing assets. If you have the means, consider using other sources of income to pay down your debt.

4. Pay off the debt as soon as possible. While it's true that you should pay off non-deductible debt first, make it a priority to pay off your deductible debt as soon as possible, too. After all, the interest you're paying, while tax deductible, is still costing you something out of your own pocket.

Selling your investments to fully pay off this debt obviously won't create an interest deduction concern since there will no longer be any interest expense.

Tim Cestnick is a chartered accountant, author and president of The Waterstreet Group Inc., a tax education and consulting firm based in Toronto.