Loan interest is still deductible on your tax return, even if your investment or business goes belly up
If you borrow money for the purpose of earning investment or business income, the interest you pay on that debt is generally tax deductible. But what if your investment turns out to be a dud and goes to zero — or you’re forced to shutter your business — while you still owe money on your loan? Should interest continue to be deductible for tax purposes long after the original source of that income has disappeared?
The answer, fortunately, comes in the form of a little-known rule in our Income Tax Act sometimes known as the “loss of source” rule. The rule, which has been in force since 1994, applies when the borrowed money no longer has the potential to generate income because the source of that potential income has disappeared. The rule, therefore, essentially permits you to continue to write off previously deductible interest expenses, even after the source of the investment or business income has disappeared.
I’ve often referred to this rule in the investing context as the “Bre-X rule,” named after the infamous mining company which went bust. For example, let’s say you had borrowed funds back in the mid ’90s to buy shares of Bre-X. The company, which started out as a penny stock and peaked at close to $300, went bankrupt in 1997 after a massive fraud involving falsified gold samples was uncovered. Well, the silver lining — pun intended — is that if you had borrowed to invest in Bre-X shares and that loan was still outstanding today, you could continue to write off your interest expense, as the funds were originally borrowed for the purpose of earning investment income.
The loss of source rule as it pertains to a business came up recently in a tax case involving a Montreal accountant who deducted $2,750 and $2,555 of interest expense on his tax returns in 2013 and 2014, respectively. From 2002 to 2007, the taxpayer was self-employed and carried on a business that provided accounting services in the communities of Brossard and Trois‑Rivières. In 2007, he incorporated his business. In the years under review by the CRA (2013 and 2014), the taxpayer was employed as a lecturer in the accounting departments of three Quebec universities.
The interest expense for the years in question arose from a variety of expenses that the taxpayer had incurred for his business back in the 2002 through 2006 taxation years. These expenses, which included rent, software subscriptions, telecommunications, professional dues, insurance, supplies and travel, totalled $93,545.
These business expenses were all paid for by cheques drawn on his home equity line of credit (“HELOC”), which was used exclusively for business purposes. In other words, he used his HELOC from March 2002 to December 2005 solely to pay for disbursements related to his chartered accounting firm, which he operated as a sole proprietorship.
After this date, the HELOC was used solely to repay the interest charged by the bank. While the HELOC was also in his spouse’s name, it was done so “for the simple reason that she was the co-owner of the family home.”
The taxpayer ended up in Tax Court because the Canada Revenue Agency denied the interest expense he claimed in 2013 and 2014. At the trial, however, the CRA conceded that two-thirds of the expenses charged to the HELOC from 2002 through 2005 were likely incurred for the purpose of earning business income, but started questioning the validity of some $21,000 of travel expenses for which the taxpayer had “a lack of supporting documentation.”
But the judge would have none of it, saying that the taxpayer “did not have to justify the deductibility of the expenses for tax purposes, because they were deducted in computing (his) income for the 2002 to 2006 taxation years and were (previously) allowed by the CRA. The only issue (today) was whether the (taxpayer) could deduct the interest expenses he incurred after he had ceased to carry on his business personally.”
The taxpayer argued that he should be entitled to continue to deduct the interest expense on the loan even though the business had ceased operating, since the loan subsisted and interest continued to be paid. He argued that under the loss of source rule, “the borrowed money is deemed to be used by the taxpayer for the purpose of earning income from the business, and that this (rule) therefore allows for the deduction of interest paid on borrowed money.”
The judge reviewed the facts and observed that as of December 2, 2005, the date of the last expense charged to the HELOC, the amount borrowed on the HELOC totalled $91,615. Subsequently, from 2006 to 2014, only interest accrued on the HELOC.
The judge then turned to the loss of source rule, which clearly provides that the portion of the borrowed money outstanding when a business ceases operating “shall be deemed to be used by the taxpayer at any subsequent time for the purpose of earning income from the business.”
The judge therefore concluded that the conditions for the application of the loss of source rule were met and therefore, the borrowed money that was outstanding when the taxpayer’s business ceased operating “shall be deemed to have been used by the (taxpayer) in the 2013 and 2014 taxation years for the purpose of earning income from the business.” As a result, the taxpayer was entitled to deduct 100 per cent of the interest expense he claimed for the 2013 and 2014 taxation years.