The difference between good and bad debt often lies in its tax deductibility. Those who leverage their assets as part of their strategic plan to build wealth, will often do so more successfully by earning more income and increasing their net worth. However, should you borrow to invest? Claiming tax deductible interest is often the only consolation for the eroding effect that the costs of debt can have on personal wealth. Here’s what you need to know this tax season:
Charges, such as carrying interest expenses may be deducted when there is a potential for earning income from property. In the case of investments, that means income from property: interest, dividends, rents and royalties. Capital gains are specifically excluded from this list. Interest is not deductible unless you acquire an asset with the potential to earn income from property.
Borrowing to Invest in Registered Accounts. When you incur expenses to invest your money, a tax deduction is only allowed if the potential to earn income is in a non-registered environment. That means interest on loans used for the purposes of investing in an RRSP, TFSA, RESP or RDSP is not deductible. Nor is interest paid on a tax-exempt property, like your principal residence, unless there is an expectation rental income will be earned.
The total carrying charges are then deducted on Line 221 and serve to offset all other income of the year, so they can be an important way to reduce overall tax burdens and increase eligibility for social benefits and credits. But for this reason, these expenses are often audited.
Audit Check Point. You must be prepared to trace all interest you have claimed back to a non-registered investment that has the potential to earn income.
Tax Filer’s Checklist. Consider the following list of deductible amounts carefully to be sure you haven’t missed any. If you have, consider filing Form T1ADJ Adjustment Request to recover these errors or omissions up to 10 years back.
Checklist of Deductible Carrying Charges
Leveraging to Invest. Now that you know what can be deducted, know this: many investors wonder if they should leverage existing capital assets in order to invest more into the marketplace. Often, they are approached to consider different leveraged loan arrangements, particularly if they believe they have not saved enough for retirement.
Be sure to crunch the numbers over the life of the loan. The potential for investment income must be present, not just from a tax point of view, but also in order for you to pay off your interest (before tax). You will need cash flow to do this. The investment must be able to pay real dollars on a guaranteed basis before your risk can be properly assessed. Otherwise you will have to dip into other funds to pay your loans. You need to assess those possibilities with your financial advisor, so that you can sleep at night.
Diminished Value in Assets. Have your assets diminished in value since you acquired them with a loan? Will your interest still be deductible in that case? The answer is yes. You can continue to deduct the interest until the loan is fully repaid, even if you sell the assets. If you did not use the proceeds to pay down the loan, then you can deduct only the portion of interest that would have been paid had you done so.
Important Tax Moves: Borrowing to invest, particularly in a low interest rate environment, will help you to build wealth. However, it’s important not to let the tax tail wag the dog. You must be able to pay back the loan, even if your assets diminish in value.
In addition, borrowing costs to invest in a registered account, like an RRSP or a TFSA will not be deductible. Remember that one of the ways to increase the returns on your investment is to be vigilant about interest costs and management fees. If you must pay them, be sure they are tax deductible.
Excerpted from Essential Tax Facts by Evelyn Jacks. You can pre-order the 2019 edition now by calling 1.866.953.4769 now. Or send an email with your request to email@example.com.
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