Subsection 20.1(1) - Borrowed money used to earn income from property
Disappearing source rules
1.41 In general terms, the disappearing source rules in section 20.1 apply where borrowed money ceases to be used for the purpose of earning income from a capital property (other than real or immovable property or depreciable property), and the borrowed money can no longer be traced to any income earning use. Generally, under these rules, the borrowed money that is no longer linked to any income-earning use is nonetheless deemed to be used for the purpose of earning income. This enables interest on this amount to continue to be deductible. ...
10 June 1996 T.I. 961113 (C.T.O. "Loss of Source Interest Deductibility")
Where a partnership is dissolved and the partners receive real property from the partnership in satisfaction of their partnership interests, and the adjusted cost base of the partnership interests at the date of dissolution of the partnership and the fair market value of the property received in satisfaction of the partnership interests is less than the original cost of the partnership interests, the decrease in the adjusted cost base of the partnership interests would not be considered to be lost because of a decline in value of property for purposes of s. 20.1 if such decrease is attributable to drawdowns by the partners of capital from the partnership, given that the borrowed money used initially to acquire the partnership interests thus would be traceable to an ineligible use. If the decrease in the adjusted cost base of the partnership interests is a result of losses of the partnership, the amount of borrowed money used to acquire the consideration for purposes of s. 20.1(1)(b)(i) would be based on the fair market value the property received in satisfaction of the partnership interests and the original cost of the partnership interests.
18 July 1995 Memorandum 950815 (C.T.O. "Loss of Source")
Interest paid by an individual on a loan made to honour a guarantee made by the individual of borrowings made by a Canadian-controlled private corporation would not be deductible under s. 20.1 because the money borrowed by the individual to honour his guarantee would not be borrowed to be used to earn income from a business or from property given that the corporation was insolvent at the time and had ceased to carry on business. Similarly, if the individual makes interest payments on the corporate loan, such interest would not be deductible because the individual making the payments has not used the borrowed money.
8 December 1994 T.I. 942208 (C.T.O. Fax Service Doc. No. 9422085)
"Where an amount is deemed by virtue of section 80.5 of the Act, to be interest paid in respect of the year pursuant to a legal obligation to pay interest on borrowed money for purposes of paragraph 20(1)(c) of the Act, and the source of income subsequently disappears, and the loan is refinanced, subsections 20(3) and section 20.1 of the Act should be applicable. Consequently ... the deemed interest on the portion of the borrowed money that has been lost should be deductible."