A friend of mine was sharing with me an anecdote about London's Hayward Gallery, which established an exhibition of invisible art where virtually everything is left to your imagination. There's one piece called 1,000 Hours of Staring that took artist Tom Friedman over five years to create. It's a blank piece of paper, and after five years the artist finally concluded that the piece was finished. I'm not sure of the entrance fee for that exhibit, but I'm pretty sure I could find another way to exercise my imagination for less money.
Tax is sort of like that. Tax deductions are in short supply and are disappearing quickly. Soon, only your imagination will be able to provide the experience of tax savings.
Interest deductions were on the endangered list a few years ago, but today still represent an opportunity for tax savings. Here's a primer on interest deductibility that could still save you tax this year if you act soon.
1. Interest is a capital expenditure. There are a number of court decisions that support this idea. This is not a good thing because capital costs are not generally deductible. And so, our tax law denies interest deductions except to the extent allowed by specific provisions of our tax law – particularly paragraph 20(1)(c) of the Income Tax Act.
2. Interest must be paid or payable. In order to be deducted your interest costs have to have been paid in the year, or be legally payable in the year. It's worth mentioning that compound interest (that is, interest on your interest) is only deductible when actually paid.
3. Interest costs must be reasonable. This is not normally an issue when you're borrowing from an arm's-length party like a bank. I've seen some strategies, however, that are designed to create a very high interest deduction at rates in excess of prevailing rates for debts with similar terms and credit risks. Be aware that the taxman can deny interest deductions in excess of a reasonable amount.
4. Interest must be paid for certain purposes. The taxman will look at the purpose of your borrowings. Interest must be incurred for the purpose of earning income from a business or property in order to be deductible. Specifically, you must have a reasonable expectation of earning income at the time the investment was made with the borrowed funds.
The good news is that your primary objective could be capital growth (earning capital gains is not considered to be earning income) as long as a secondary objective is to earn income. It's not even critical that the income you expect to earn be in excess of your interest costs for those costs to be deductible (although in Quebec you won't be able to deduct interest in excess of your investment income in a given year; excess interest can be carried back up to three years or forward indefinitely to be deducted in the future when income – including taxable capital gains – is earned. This is strictly a provincial rule and doesn't apply to your federal tax filings or outside of Quebec).
5. Interest can't relate to exempt income. If you've borrowed money to invest for the purpose of earning income that will be exempt from tax or to acquire a life insurance policy you won't generally be able to deduct your interest costs (there are some exceptions to the life insurance rule). Money borrowed to contribute to your RRSP, registered education savings plan (RESP) and TFSA, for example, will not provide an interest deduction.
6. The direct use of the borrowed money matters. It's important that the taxman be able to trace the use of your borrowed money to an identifiable use before a deduction will be allowed. That use should be to earn an income, as I discussed earlier. By the way, it's the current use of the borrowed money that matters. So if you borrow to invest, then sell those investments, you'll can continue deducting interest only if you reinvest to earn income again.
7. A disappearing investment can still provide deductions. Suppose you borrow $1,000 to invest and the asset drops in value to $600, then you sell the asset and use the $600 to pay down your debt. If you're still left with debt you can generally continue to deduct the remaining interest costs in this case. There are a few similar situations where interest may continue to be deductible despite the asset being gone. Section 20.1 of our tax law says so.
Next time I'll share some practical strategies to create tax savings right away.
Tim Cestnick