Monday's announcement by Finance Minister Jim Flaherty that, come April, the government will stop offering mortgage insurance on home equity lines of credit (HELOC) has exposed what many in the industry have known for years that HELOCs were seldom used to finance the equity in your home but rather to fund a variety of other things, including "boats and cars and big-screen TVs."
Tax planners are often besieged with questions from clients who have taken out a HELOC or a mortgage and are wondering whether, given their own set of circumstances, some or all of their interest expense is tax deducible.
The ability to write off interest paid on a loan has its origins in the Income Tax Act which states that if funds are borrowed for the purpose of earning business or investment income, the interest paid on such funds is tax deductible.
Last year, the Canada Revenue Agency was asked to comment about a specific restructuring arrangement and whether interest could be tax deductible.
In the case posed to CRA, the taxpayer, who we'll refer to as Joey, wants to buy a new home and rent out his current home, valued at $700,000, which is fully paid off and thus is unencumbered by a mortgage.
If he simply goes to his lender to secure financing on his new home, the interest on his new mortgage won't be tax deductible since he is not borrowing for the purpose of earning income but rather is borrowing to purchase his new principal residence a personal property.
Instead, Joey, with the advice of his astute tax advisor, decides to sell his principal residence to his parents for the fair market value of $700,000. His parents, not having the $700,000 cash lying around to cover this purchase, pay him by way of a promissory note.
Joey then obtains a mortgage or HELOC and uses the proceeds from this loan to buy back the house from his parents, to use as a rental property. His parents use the proceeds of the loan to pay off the promissory note. Joey, now flush with cash, uses the re-acquired property for rental purposes and purchases his new principal residence with the cash.
The reason for these complex maneuverings is to ensure that Joey meets the "direct use test" as outlined in the CRA's Interpretation Bulletin on interest deductibility which states that in determining what borrowed money has been used for, the onus is on the taxpayer "to trace or link the borrowed money to a specific eligible use, giving effect to the existing legal relationships." The Bulletin goes on to say that "a taxpayer may restructure borrowings and the ownership of assets to meet the direct use test."
As a result, the CRA blessed Joey's proposed transactions and said that the mortgage or HELOC interest would indeed be tax deductible.