A tax mistake that is often made on the sale of a principal residence is an interest-bearing mortgage
Maroney on Money for June 8, 1997
In my last article I reviewed an income tax planning mistake that is frequently made a when taxpayer's principal residence is converted into a rental property. The issue related to the loss of tax deductible interest due to a poorly planned transaction.
Recall, that Revenue Canada will look to the use of borrowed funds in order to determine whether interest payments are deductible for income tax purposes. If the borrowed funds are used to earn investment income then, in most cases, the interest paid will be deductible.
Another mistake that is often made on the sale of a principal residence was highlighted in a recent case before the Tax Court of Canada.
In this case, Mr. S sold his principal residence with a view to constructing a new and better replacement. Unfortunately, the purchaser was unable to raise the cash required to complete the transaction.
Being a nice guy and not wishing to see the deal collapse, Mr. S offered to take back an interest-bearing mortgage as part of the proceeds on the sale of his house. He then borrowed a like amount from the bank in order to complete construction of his new home.
Mr. S thought he could deduct the interest he was paying to the bank against the interest he was receiving from the purchaser of his old home. Revenue Canada thought otherwise and the whole matter ended up before the courts. Unfortunately for Mr. S, the judge sided with Revenue Canada and disallowed the interest deduction since the borrowed funds had been used for a non-deductible purpose, namely the construction of his new house.
Could Mr. S have done things differently and saved himself a headache or two? Absolutely, but the thinking must be done before the transaction and not after the fact.
Mr. S could have borrowed the necessary funds from his bank and advanced these directly to the purchaser in return for an interest-bearing mortgage on the first residence. The security provided to the bank could have consisted of an assignment of the mortgage Mr. S received from the purchaser. On closing the sale of the first property, the purchaser would then pay the cash he received back to Mr. S. The cash so received could then have been used by Mr. S to complete construction of his new home.
In following this approach, Mr. S would have created tax deductible interest. The funds he borrowed from the bank were used to earn interest income by way of the interest-bearing mortgage he provided to the purchaser. In this case there is a clear connection between the interest paid to the bank and the interest received on the investment. As a result, the interest paid is deductible for tax purposes.
The difference between the actual approach and the suggested approach may be subtle, however, the difference in outcome can be substantial. The key point to be made is that a bit of thought ahead of time can pay substantial dividends in the future.
Jim Maroney is a chartered accountant with Andrews, Brown, Maroney in Maple Ridge.
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