Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.
Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.
Principal Issues: Mortgage interest deductibility when a mortgage on a principal residence was taken out to purchase another residence.
Position: The direct use of the borrowed funds is the test that predominates in determining the deductibility of the interest.
Reasons: The Queen v. Bronfman Trust (87 DTC 5059)
XXXXXXXXXX 2000-004265
Franklyn S. Gillman
October 25, 2000
Dear Madam:
Re: Mortgage Interest Deductibility
We are replying to your letter of August 7, 2000, in which you inquire how the principal residence exemption works, whether interest on a mortgage in respect of a principal residence may be deducted and if capital cost allowance may be claimed following a change of use.
A summary of the situation you provided is that an individual took out a mortgage on a principal residence and used the funds for personal needs. After taking out the mortgage, the individual moved out of the principal residence and started using it as an income producing property.
As was discussed during the telephone conversation (XXXXXXXXXX/Gillman) of September 19, 2000, written confirmation of the tax implications inherent in particular transactions are given by this Directorate only where the transactions are proposed and are the subject matter of an advance income tax ruling request submitted in the manner set out in Information Circular 70-6R3. As stated in paragraph 21 of Information Circular 70-6R3 written opinions are not advance rulings and, accordingly, are not binding on the Department. The following comments are, therefore, of a general nature only. A more complete understanding as to the workings of the principal residence exemption may be found in Interpretation Bulletin IT-120R5 Principal Residence.
The term "principal residence" is defined in section 54 of the Income Tax Act (the "Act"), and the principal residence exemption is claimed under paragraph 40(2)(b) of the Act.
Generally, a housing unit may be designated as a principal residence for each year that it is ordinarily inhabited by the taxpayer or by his or her spouse or child, during which he/she was resident or deemed to be a resident in Canada. Where a property qualifies as an individual's principal residence, the principal residence exemption may be used by that individual to reduce or eliminate any capital gain otherwise occurring either when the property is disposed or deemed to be disposed. Please see paragraph 7 of IT-120R5 for a detailed explanation of the calculation.
Change in Use
Where the owner of a principal residence ceases to live in the property and commences to use the building as an income producing asset, there would be a deemed disposition and immediate reacquisition of the property converted to the new use for proceeds and cost equal to the property's fair market value. Any resulting gain on the deemed disposition is usually eliminated by the principal residence exemption (as suggested above, see paragraph 7 of IT-120R5 for an explanation of the calculation of the amount eligible for the exemption.)
Deferred recognition of any gain to a later year is possible by electing under subsection 45(2) to be deemed not to have made the change in use of the property. This election by the taxpayer is made by signing a letter to that effect and filing it with the income tax return for the year in which the change in use occurred. If the taxpayer revokes the election in a subsequent year, the property is deemed to have been disposed of and reacquired at fair market value at that time. Should capital cost allowance ("CCA") be claimed on the property in a subsequent year, the election is considered to be revoked on the first day of the year in which the CCA claim is made. Please refer to paragraph 25 of the interpretation bulletin for a more detailed explanation.
Capital Cost Allowance
With regards to the ability to claim capital cost allowance subsequent to a change of use of a principal residence, paragraph 33 of the bulletin states the following:
"If a taxpayer has completely or partially changed the use of property from principal residence to income-producing, subsection 13(7) provides for a deemed acquisition of the property or portion of the property so changed that is depreciable property. For purposes of claiming CCA, the deemed capital cost of such depreciable property is its FMV as of the date of the change in use unless that FMV is greater than its cost to the taxpayer. In that case, the deemed capital cost of such depreciable property is equal to its cost to the taxpayer plus an amount which represents the taxable portion of the accrued gain on the property (before any reduction to that gain by means of the principal residence exemption) to the extent that a section 110.6 capital gains deduction has not been claimed in respect of that amount (this latter rule has no particular significance for dispositions of residence properties occurring after February 22, 1994, because of the elimination of the $100,000 lifetime capital gains exemption for dispositions after that date)."
Reassessment
As for any tax returns already filed, it may be possible to have them reassessed under section 152 of the Act. The Agency has issued Information Circular IC75-7R3 Reassessment of a Return of Income. At paragraph 4 it states the following:
"4. A reassessment to create a refund ordinarily will be made upon receipt of a written request by the taxpayer, even if a notice of objection has not been filed within the prescribed time, provided that
(a) the taxpayer has, within the four year filing period required by subsection 164(1), filed the return of income; (b) the Department is satisfied that the previous assessment or reassessment was wrong;
(c) the reassessment can be made within the four year period or the seven-year period, as the case may be, referred to in paragraph 1 above or, if that is not possible, the taxpayer has filed a waiver in prescribed form;
(d) the requested decrease in taxable income assessed is not based solely on an increased claim for capital cost allowances or other permissive deductions, where the taxpayer originally claimed less than the maximum allowable; and
e) the application for a refund is not based solely upon a successful appeal to the Courts by a taxpayer.
Ordinarily a taxpayer must set out specifically what is considered to be wrong in the assessment for the year."
As stated in subparagraph 4(d) above, a reassessment to create a refund will not be permitted where the request is based solely on an increase claim for capital cost allowance, where the original claim was less than the maximum allowable. In our view, this would not be the case where a taxpayer also requests a correction to reduce the amount of interest expense previously claimed in error.
Deductibility of Mortgage Interest
Generally, interest paid or payable in the year on borrowed money is deductible by virtue of paragraph 20(1)(c) of the Act if the borrowed money is used to produce income or to acquire property to produce such income. In our view, mortgage interest with respect to funds borrowed, using a principal residence as collateral and directly used to purchase another residence or personal use property would not be deductible for tax purposes where the original principal residence is later used as an income producing property. This view is supported by the Supreme Court of Canada decision in The Queen v. Bronfman Trust (87 DTC 5059) where the Court concluded that the direct use of the borrowed funds is the test that predominates in determining the deductibility of the interest. Accordingly, we agree with your view that, in this situation, the interest would not be deductible.
Common-law Relationship
Paragraph 252(4)(a) of the Act, which sets out the guidelines for determining a common-law spouse until the end of 2000, states that:
"words referring to a spouse at any time of a taxpayer include the person of the opposite sex who cohabits at that time with the taxpayer in a conjugal relationship and
(i) as so cohabited with the taxpayer throughout a 12 month period ending before that time, or
(ii) is a parent of a child of whom the taxpayer is a parent (otherwise than because of the application of subparagraph 2(a)(iii))
and, for the purposes of this paragraph, where at any time the taxpayer and the person cohabit in a conjugal relationship, they shall, at any particular time after that time, be deemed to be cohabiting in a conjugal relationship unless they were not cohabiting at the particular time for a period of at least 90 days that includes the particular time because of a breakdown of their conjugal relationship".
We would like to comment on your suggestion that when an individual taxpayer makes a contribution to an RRSP naming another individual as the annuitant, i.e., a contribution to a spousal RRSP, that this occurrence would confirm the common-law relationship. The fact that an individual make a contribution to an RRSP that he/she terms a contribution to a spousal RRSP would not, in our view, confirm that a common-law relationship exists between the two parties. Whether or not a common-law relationship exists is a question of fact. Such a contribution may be supporting evidence but inconclusive on its own.
We encourage you to direct specific questions regarding the tax implications of your particular client in respect of past events to the local tax services office. We would be glad to provide assistance to the tax services office if they so request.
We trust these comments will be of assistance.
Yours truly,
for Director
Business and Publications Division
Income Tax Rulings Directorate
Policy and Legislation Branch
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