Principal Issues: [TaxInterpretations translation] A mortgage loan is used partly to finance a rental property, partly to finance the purchase of a principal residence and partly for personal purposes. What portion of the interest is deductible?
Position: (1) Interest on the portion of the loan that is used to earn income from the rental property.
Reasons: (1) Paragraph 20(1)(c): the loan must be used to earn income.
2010-036210 XXXXXXXXXX Catherine Ayotte, Notary, M.Fisc. April 28, 2010
Dear Sir,
Subject: Paragraph 20(1)(c)
This is further to your e-mail of March 27, 2010, in which you asked us to comment on interest deductibility in the situation described below.
Please note that unless otherwise indicated, all legislative references herein are to the provisions of the Income Tax Act (the "Act").
It appears to us that the situation described in your letter may constitute an actual situation involving taxpayers. As explained in Information Circular 70-6R5, it is not the Directorate's practice to comment on proposed transactions involving specific taxpayers otherwise than in the form of an advance income tax ruling. If your situation involves a specific taxpayer and a completed transaction, you should provide all relevant facts and documentation to the appropriate Tax Services Office for its views. However, we are prepared to provide the following general comments that may be helpful to you.
Facts
An individual bought a three-unit rental property and financed the purchase with a loan (Loan #1) secured by a mortgage on the property. Until January 1, 2007, 46% of this property (one of the three units) was used as a principal residence. On that date, the individual purchased a new immovable that became his principal residence (the "residence"). The unit of the rental building that he had used as his principal residence changed use and the entire rental building was then used entirely to earn income.
On the same date, the individual borrowed additional amounts that were added to Loan #1 and the increase in his loan was also secured by a mortgage on the rental property. The increase in this loan was used partly for personal use and partly to finance the purchase of the residence. In order to complete the financing of his residence, the taxpayer obtained an additional loan (Loan # 2) secured by a mortgage on his residence.
Our Comments
Subparagraphs 20(1)(c)(i) and 20(1)(c)(ii) permit the deduction of interest where all the conditions set out in those subparagraphs are satisfied.
Subparagraph 20(1)(c)(i) provides inter alia that the amount to be deducted must be paid or payable pursuant to a legal obligation to pay interest on borrowed money used for the purpose of earning income from a business or property (other than borrowed money used to acquire property the income from which would be exempt or to acquire a life insurance policy).
In light of the jurisprudence (endnote 1), the applicable test is the direct use of the borrowed money. In this regard, the relevant use is the current use and not the original use of the borrowed money. To determine the current use of the borrowed money, taxpayers must establish a link between the borrowed money and its current use.
You stated that there had been a change in use of the personal portion of the rental property so as to be used entirely to earn income. The original use of the portion of Loan # 1 (46%) was for a personal purpose (residence) that was not a qualifying purpose but, due to the change in use, the current use of this portion of loan # 1 became a qualifying purpose and the interest related to this portion of the loan becomes deductible upon the change in use.
The interest eligible for a deduction on Loan # 1 after the additional funding was provided was the interest on the portion of the loan that was currently being used to earn income. Based on the facts submitted, this would be the interest on the balance of Loan # 1 before the additional financing that is used to finance the rental property. However, the portion of this loan (additional financing) that was used for personal purposes or to acquire the residence was not used to earn income and, consequently, any interest paid or payable on this portion was not deductible.
The nature of the security provided in respect of borrowed money does not affect the conditions for interest deductibility.
We hope that our comments are of assistance.
Best regards,
Ghislain Martineau
Manager
Financial Sector and Exempt Entities Section
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch.
ENDNOTES
1 Canada Safeway Ltd. v. Minister of National Revenue. [1957] S.C.R. 717
Bronfman Trust v. The Queen, [1987] 1 S.C.R. 32
Shell Canada Ltd. v. Canada, [1999] 3 S.C.R. 622