Jim Maroney
MNP
B.B.A. (Hons), C.A.
Chartered Accountant

Moving? Don't Get Caught In The "Big Trap"

If you're considering moving, make sure you're not caught in the big trap. This happens when people live in their humble abode for time eternal until the mortgage is finally paid off. Along with the urge to move to a new home, comes a desire to hang on to old "Betsy" and make some money on the side in the form of rental income. Often the mortgage-free homeowner heads off to the bank to borrow whatever money is needed to purchase a new piece of paradise. In many cases, the old home is provided as security to the lender for the purchase of the new home. The intent being to move into a new home, rent out the old home and write-off the interest on the new mortgage. Sounds pretty simple, so what's the problem?

The mistake that has been made here is to confuse the security for the loan with the use of the borrowed funds. Revenue Canada isn't particularly concerned about the security provided for the borrowed money. They are, however, very concerned about what the borrowed funds were used for. If the borrowed money is used to earn investment income, chances are the interest paid will be deductible. On the other hand, if the borrowed money is not used to earn investment or business income deductibility of interest is nothing more than wishful thinking.

In the situation described, the borrowed money has clearly been used to finance the purchase of a principal residence. As we all know, interest paid to purchase your own home is not tax deductible. The fact that the old home (which is now a rental property) has been pledged as security doesn't suddenly make the interest deductible.

The absence of interest deductibility is even more painful when you consider that the income received from rental of the old home is fully taxable. This certainly doesn't sound like prudent financial planning to me but what could have been done in the alternative?

The homeowner could have chosen to sell the old home. In most cases, the proceeds will be received free of tax. The proceeds so received could then be used to buy the new home. Then, using the new home as security, funds could be borrowed to acquire a "new" rental property. Since the borrowed money has been used for investment   purposes (i.e., to earn rental income) the interest should be tax deductible and can be ap
plied as an offset against the rental income received.

Notice that the individual has used their principal residence as security for the mortgage financing yet the interest is tax deductible. This is the exact opposite of the original scenario. The unfortunate part, however, is that the old home had to be sold in order to minimize the tax bite. Sometimes it pays to be a stoic.


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