All the Numbers

Interest on borrowed money

From the All the Numbers wiki · Renting part of a home

Interest on a mortgage is a personal cost for the part of a home you live in and a deductible rental expense for the part that earns rent. The rule that separates the two is about what the borrowed money is used for.

The current-use test

Interest is deductible only when the borrowed money is used for the purpose of earning income from property. The test is the use the money is put to now, not the use it was first borrowed for and not the property that secures the loan.[1] A loan secured on a rental building but spent on a car is not deductible, and a loan secured on a house but spent on renovating a rented unit is.

For a purchase of a home with a rented suite, the rented share of the money is the share spent to earn the rent. The planner takes that share to be the share of the floor space rented.

Refinancing

Money borrowed to repay borrowed money is treated as used for the purpose the repaid money was used for.[2] A refinance therefore keeps the deductible share of the old loan. Any new money advanced in the refinance has the use it is put to.

Repayments

When a loan has both a deductible and a non-deductible part, a repayment of principal reduces the two parts in proportion. Paying down the mortgage does not use up the non-deductible part first.[3]

Fees

The cost of obtaining a mortgage on a rental property is not deducted all at once. Items such as an appraisal, a broker, mortgage legal fees and the default-insurance premium are deducted evenly over five years.[4]

What the engine and the planner do

  • The engine keeps each loan as separate lots with their own income-use share. It applies a repayment to the lots in proportion, adds a refinance advance as a new lot and leaves the existing lots with their use.
  • The planner has one mortgage per home and no refinance, so the deductible share is a single fixed share: the rented share of the floor space, from the month the rental starts. It is a figure the plan takes as given, not one worked out from how the money was used.
  • The planner does not deduct the fees to obtain the mortgage or the default-insurance premium against the rent; see mortgage default insurance.
  • Not modelled: interest that continues after the income source is gone, and a prepayment penalty paid to refinance debt used to earn income, which is treated as interest spread over the remaining term. The engine refuses such a refinance.

See also

  • How a mortgage payment is worked out · A fixed-rate Canadian mortgage compounds its interest twice a year, not monthly, so the monthly payment comes from a rate slightly lower than the quoted rate divided by twelve. The default rate is 4.27%, and the rate stays fixed for the whole amortization.
  • Mortgage default insurance · A buyer putting down less than 20% must buy mortgage default insurance from CMHC or a competitor. The premium is 2.80%, 3.10% or 4.00% of the loan depending on the down payment, is added to the mortgage, and carries 8% Ontario sales tax paid in cash at closing.
  • Renting out a suite · Rent from part of your home is taxable income. The costs of the whole home are deductible only for the rented share, mortgage principal and land transfer tax are not deductible, and a loss offsets other income when the rental is run to earn money. A lender may count part of the rent when you apply.
  • When the plan runs short of cash · When a month needs more money than the plan has, it draws savings in a set order, then borrows on a home equity line at 5.13% and an unsecured line at 8.38%, as far as a lender would lend. When no lender would lend more, the projection stops.

References

  1. ↑Income Tax Folio S3-F6-C1, Interest Deductibility · Interest deductible only when borrowed money is used for the purpose of earning income from property; the test is the current use, not the original use or the collateral · effective 2024-08-08
  2. ↑Income Tax Folio S3-F6-C1, Interest Deductibility · Money borrowed to repay borrowed money is deemed used for the purpose the repaid money was used for (refinancing keeps the old loan's deductible share) · effective 2024-08-08
  3. ↑Income Tax Folio S3-F6-C1, Interest Deductibility · Mixed-use borrowing: a principal repayment reduces the eligible and ineligible portions proportionately · effective 2024-08-08
  4. ↑Guide T4036 Rental Income — Chapter 3 · Fees to obtain a mortgage on a rental property (appraisal, broker, application, mortgage legal, default-insurance premium) are deducted evenly over this many years · 5 years · effective 1972-01-01