Plan Properly and You Can Deduct Mortgage Interest
February 28th, 2017
As a homeowner, you may covet the fact that U.S. taxpayers can deduct mortgage interest on their income tax returns. But take heart; there are strategies that let you accomplish essentially the same result here.
The overriding rule in Canada is that to be able to deduct interest payments, the borrowed money must earn income.
This is why mortgage interest is excluded — home loan funds are generally spent to purchase a personal residence or vacation cottage and aren’t generating earnings.
But what if there was a way to make the interest tax deductible? Here are some tactics that can help you accomplish that goal.
Strategies for Your Home
Home Business: When you run a business from your home, you can deduct a portion of the mortgage interest paid that is equal to the area of the property that is used to earn income. The mortgage-interest deduction is based on the square footage of your work area divided by the square footage of the house. If you work out of two rooms that total 240 square feet and the house is 2,400 feet, you are using 10 per cent of the building’s space for work.
When you file your income tax return then, you can deduct 10 per cent of your mortgage interest. It’s also important to keep close tabs on all household spending. You can deduct the same percentage of property taxes, maintenance costs, heating, electricity, home insurance and cleaning materials. You can also deduct a portion of your capital cost allowance.
Rental Income: The same principle applies when you rent part of your principal residence – whether it’s a basement suite or a single room. You deduct the interest and all other expenses related to that area of the home. If you rent the entire home or vacation property for several months, you can deduct all the mortgage interest and other costs for that period.
The Question of Investments
Of course you can deduct mortgage interest on residential investment properties. If you take out a mortgage to purchase a property and rent it out, it is earning income and produces a tax deduction.
For example, say you buy a building with rental units for $400,000 and you take out a $300,000 mortgage at 5 per cent. In your first year, you take in $33,600 in rental income. You get to deduct $15,000 in interest payments from those earnings, cutting taxable income to $18,600. On top of that, you get the other wide range of deductible expenses, such as property tax, maintenance, utilities, insurance, and administrative and legal fees.
Even if you don’t operate a home business, rent a part of your residence, or own an apartment building, you can still deduct mortgage interest as long as you can determine how much of the borrowed money you are using to earn income. The simplest way to do that is to take out a mortgage and put the money into an investment.
If you already have a home loan, there are two investment strategies that will allow you to deduct some or all of your mortgage interest.
Asset Swap: When you hold investments outside your Registered Retirement Savings Plan (RRSP), you can carry out an asset swap where you:
- Sell some or all of the investments;
- Purchase a home using cash from the investment sale;
- Take out a mortgage on your new home; and
- Use the new mortgage money to purchase investments.
The new mortgage becomes an investment loan and the interest is fully deductible.
Borrowing Against Equity: Even if you don’t have investments outside your RRSP, you can borrow money against the equity in your home and invest the proceeds by:
- Renewing your mortgage for a higher amount;
- Taking out a second mortgage; or
- Drawing on a home equity line of credit.
Critical move: You must clearly demonstrate a direct link between the mortgage proceeds and the investment income. Some advisers recommend waiting 30 days before repurchasing the same investments in an asset swap. This helps make it clear that there have been two separate actions: selling investments to buy a house and then borrowing against the house to make income-producing investments.
There are a number of specialized mortgage products and other strategies available to help segregate the borrowed funds so that the maximum interest can be deducted. It is important to talk to your accountant or professional adviser to determine the best strategy for you.