2 July 2002 External T.I. 2002-0142035 - INTEREST DEDUCTIBILITY CHANGE IN USE

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 CCRA.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ADRC.

Principal Issues:

Deductibility of mortgage interest on borrowed money used to acquire a principal residence.

Position: In the situation provided it is not deductible.

Reasons: The direct use of the borrowed funds is for an ineligible use.

XXXXXXXXXX 						2002-014203

July 2, 2002

Dear XXXXXXXXXX:

Re: Mortgage Interest Deductibility

We are replying to your letter of January 27, 2002, in which you inquire whether interest on a mortgage may be deducted. In the letter, you provided the following facts:

1. You currently own and occupy with your common-law spouse, a principal residence, located at XXXXXXXXXX ("Property A").

2. In XXXXXXXXXX, you borrowed $XXXXXXXXXX secured by a mortgage on Property A representing XXXXXXXXXX% of the value of the property ("Mortgage A"). The funds were used to acquire a property and construct a new principal residence located at XXXXXXXXXX ("Property B"). In addition, you borrowed $XXXXXXXXXX, secured by a mortgage on Property B ("Mortgage B"). The funds were also used in the construction of your new principal residence.

3. Once you occupy Property B, Property A will be converted into a rental property.

You have requested our comments with respect to the deductibility of interest with respect to the above-mentioned mortgages with Case Law citations to support our position.

Our Comments

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 ruling request submitted in the manner set out in Information Circular 70-6R5. As stated in paragraph 22 of Information Circular 70-6R5, written opinions are not advance tax rulings and, accordingly not binding on the Agency. The following comments are, therefore, of a general nature only.

Mortgage Interest Deductibility

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. The Supreme Court of Canada decision in The Queen v. Bronfman Trust (87 DTC 5059) has established that the direct use of the borrowed funds is the test that predominates in determining the deductibility of interest expense.

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. This view is supported by numerous Court decisions.

In McLeod v. M.N.R. (64 DTC 218), the taxpayer decided to convert the mortgage-free house in which he and his family were residing into a duplex and to move to a new smaller home, his intention being to obtain investment income and build up an estate. To finance the purchase price of $18,000 for the new house, the taxpayer arranged for a $9,000 mortgage on the old house and a $7,000 mortgage on his new home, and used $2,000 of his own funds. Interest on the said mortgages was disallowed. The taxpayer appealed to the Tax Appeal Board, which dismissed the appeal on the basis that the borrowed money was not used for the purpose of earning income from a business or property.

In Hills v. M.N.R., (70 DTC 1429), the taxpayer and his wife were the joint owners of a home, 25% of which was used for the purpose of producing income through rentals. To purchase the home, the taxpayer obtained a bank loan on which interest was paid. The taxpayer deducted the full amount of interest on the borrowed money, 75% of which was disallowed. When the taxpayer appealed to the Tax Appeal Board, the Board ruled that since only 25% of the house was used for the production of income, only 25% of the interest on money borrowed to purchase the house could be allowed as a deduction. The remaining 75% of the bank interest was a non-deductible personal or living expense.

In Holmann v. M.N.R. (79 DTC 594), the taxpayer mortgaged a rental property which he owned in order to have sufficient funds to acquire a principal residence. He then claimed the interest expense as a deduction. When the interest expense was disallowed, he appealed to the Tax Review Board where he contended that the borrowed money allowed him to retain the rental property while acquiring a principal residence, rather than selling the rental property and using cash from the sale to finance the acquisition. The appeal was dismissed, where the Board concluded that the interest charges were personal or living expenses, were not incurred for the purpose of earning income from a business or property, and therefore were not deductible.

In The Queen v. Attaie, the taxpayer acquired a residence in Canada. The purchase was partially financed by a mortgage, the interest on which was deducted by the taxpayer from rental income received from January to May 1980. In June 1980, the taxpayer and his family began to occupy the residence as their principal residence. Instead of using a portion of a $200,000 amount that the family brought from Iran to repay the mortgage, the taxpayer invested the $200,000, producing interest income thereon. The taxpayer continued to deduct the mortgage interest paid after they occupied the residence, which was disallowed. Both the Tax Court of Canada (85 DTC 613) and the Federal Court - Trial Division (87 DTC 613) agreed with the taxpayer that the interest is deductible. However, the Federal Court of Appeal (90 DTC 6413) overturned these decisions on the basis that once the taxpayer had ceased using his house to generate rental income, interest paid on the mortgage thereon was no longer deductible, regardless of the fact that the taxpayer chose to invest the funds from Iran in order to generate income rather than using a portion thereof to pay off the mortgage.

In Cascone v. The Queen, (2000 DTC 1621), a taxpayer and his spouse ("the taxpayers") acquired one property ("Property 1") in 1978, which was used as a principal residence. In January 1988, the taxpayers acquired a second property ("Property 2") and financed the acquisition with a $220,000 mortgage registered on Property 1. The taxpayers moved into Property 2 in February 1988 and commenced to rent out Property 1. Property 2 was eventually sold in October 1988, with the proceeds being used to acquire a third property ("Property 3"). The taxpayers' claimed an interest deduction against the rental income, which was denied. Their appeal to the Tax Court of Canada was dismissed with the Court ruling that the borrowed funds were never "used for the purpose of earning income". They were used to purchase a property (Property 2) that never earned income (as rent), but was only used as a principal residence, and was eventually sold.

Principal Residence - Change in Use

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 of the amount eligible for the exemption.

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 in the preceding paragraph).

Deferred recognition of any gain to a later year is possible by electing under subsection 45(2) to deem 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.

In respect of interest deductibility, it is the current use made of the borrowed funds in a particular year rather than the initial use of the funds that must be considered in determining whether the interest paid or payable with respect to the borrowed funds is deductible in a particular year. It is our view that interest paid or payable on borrowed funds to acquire an asset will be deductible from the date that particular asset is fully used to produce income from a business or property. In the situation described in your letter, interest on Mortgage A would not be deductible because the initial and current use of the borrowed funds was to acquire and construct your new principal residence, Property B. If Property B was subsequently changed to become a rental property, the interest on Mortgage A and Mortgage B would be deductible.

However, we are currently in the process of reviewing our existing positions on interest deductibility subsequent to the recent decisions of the Supreme Court of Canada on interest deductibility. You may wish to contact us subsequent to the completion of our study this fall to confirm our positions at that time.

We trust the above comments will be of assistance to you.

S. Tevlin
for Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch