May 2001

Clarifying Tax Deductibility
When Borrowing to Invest

© Talbot Stevens

The concept of borrowing to invest, or leveraging, is an advanced wealth-creation strategy that is poorly understood by most investors. As I show in my new booklet Dispelling the Myths of Borrowing to Invest, leverage is simply a tool that can help or hurt investors depending on how it is used.

Because of the complexity of the math, most people do not understand when leveraging makes sense. In addition, many are not clear about when the interest expense is tax deductible. Unfortunately, the government itself is responsible for much of this controversy.

Most investors know that if you borrow to invest in RRSPs, the interest expense is not tax deductible. The RRSP contribution is. With traditional leveraging outside of RRSPs, the interest expense is often tax deductible, but the amount invested is not.

The Income Tax Act allows you to deduct any interest expenses if the borrowed money is invested “to produce income”.

One source of confusion is a lack of understanding on what types of investments qualify for the interest to be deductible. Equity investments like mutual funds and common stocks offer the potential for the highest long-term returns and are the most popular type of investment for leveraging.

The deductibility issue was muddied more in the last few years when Revenue Canada, now called Canada Customs and Revenue Agency or CCRA, stated in the T1 General tax guide that interest is not tax deductible if the investment produces capital gains. Only interest and dividends count as income

Because equity mutual funds often produce only capital gains, many felt the interest was not deductible when leveraging equity funds, even though the government's practice was to allow it.

The good news is that the government has finally clarified their position on this issue. In technical interpretation 2000-0036435, CCRA states that interest expenses are generally deductible when borrowing to invest in mutual funds or common shares. Segregated funds also qualify.

However, leveraging investors must be careful to keep their interest expense tax deductible. As long as the borrowed money remains invested for the purpose of producing income, the interest remains 100% deductible. If any of the leveraged investment is withdrawn and used for personal purposes, a portion of the interest will cease to be deductible.

Let's say you borrow and invest $20,000, which grows to $30,000. If you withdraw $10,000 for any non-business or non-investment purpose, one-third of the interest would not be deductible from that point on.

One final clarification for those who use Systematic Withdrawal Plans to automatically pay the interest expense. Since 100% of the loan remains invested, 100% of the interest is deductible, even if withdrawals are made to pay down the loan, or to make the interest payments.

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