The perils of writing off the mortgage

National Post

2009-08-22


It has been nearly six months since the Lipson decision, in which the Supreme Court
of Canada effectively blessed the debt-swap strategy known as the "Singleton
shuffle." But a new court decision reminds us how critical it is when rearranging
your debt to do so legally.

After all, in Canada, it's nearly impossible to write off your mortgage interest
without some advance planning.

The Singleton shuffle, named after Vancouver lawyer John Singleton's 2001 Supreme
Court victory, stands for the notion that you can rearrange your financial affairs
to make the interest on investment loans tax-deductible. How you do that is by
replacing non-deductible debt with tax-deductible debt.

The case decided last month involved Nina Sherle, who owned a rental property
(Property A) with a mortgage on it upon which the interest was deductible. She also
owned a personal residence (Property B) free and clear.

She wanted to switch properties. In other words, she wanted to live in Property A as
her personal residence and rent out Property B. She stated she didn't want to change
her financing strategy, which was to live in her personal residence (soon to be
Property A) mortgage-free.

To accomplish this, she mortgaged Property B to pay off the loan on property A. As a
result, she was now making interest payments on the new mortgage secured by Property
B. She deducted this interest on her tax returns but was reassessed by the Canada
Revenue Agency.

The CRA argued that for interest to be deductible, one must look to "the actual,
direct use of the borrowed funds" and whether such use was for the purpose of
earning income.

Since the mortgage proceeds were used to pay off the loan on Property A, which was
to be a personal residence, not an income-producing property, the interest was not
taxdeductible.

The judge in the case agreed. He wrote: "Why funds are borrowed is irrelevant.... It
is the use of the funds that governs [the decision]. In the present case, the
required link between the use of the proceeds and the income-producing property is
just not there."

In a twist, the judge went on to describe what Ms. Sherle could have done to permit
the interest to be deductible. While somewhat complex, it essentially involves Ms.
Sherle selling Property B to a friend in return for a promissory note.

The next day, Ms. Sherle could have borrowed money from the bank to pay off the
mortgage on Property A. She then could buy back Property B from her friend,
financing that purchase through a mortgage on Property B.

Her friend would take the proceeds from the sale of Property B and use them to repay
the promissory note. Finally, Ms. Sherle would use the proceeds from the promissory
note to pay off the bank loan.

Confused yet? The end result is that only the mortgage on Property B would be
outstanding. The interest should be taxdeductible since the direct use of the
mortgage proceeds was to buy the rental property.