By Keith Vincent
When we first met Miss Take she had made the unfortunate error of borrowing to acquire a new principal residence. She did not realize that the interest on the borrowed funds would not be deductible against the rental income from the property which was now being rented out. Even though the borrowing was against the equity in her rental property, the direct use of the funds was to acquire a new personal home so the interest on this borrowing was not deductible.
As the other articles mentioned, some restructuring to obtain interest deductibility is possible with the right planning. But once the error has been made, can it be fixed?
Miss Take did not want to involve other individuals to help her with her planning, so she decided to investigate other options. After talking with her advisor, they came up with the following plan:
• Miss Take incorporates a new company (“Newco”) and becomes Newco’s sole shareholder.
• Miss Take transfers her old home to Newco and as consideration; Newco issues a promissory note equal to the value of the property. In simple terms, I’ve assumed that this transaction is happening shortly after the conversion to a rental property. The gain realized by Miss Take on the conversion is sheltered with her available principal residence exemption.
• Newco borrows from the bank an amount equal to the promissory note.
• Newco uses the borrowed funds to repay the promissory note owing to Miss Take.
• Miss Take uses the funds received from Newco to repay the mortgage used to acquire her new principal residence.
What has been accomplished here? Newco now has an interest-bearing loan owing to the bank. Even though Newco did not use borrowed funds to acquire the rental property, it used the borrowed funds to repay an amount payable for property acquired for the purpose of earning income. As such, the bank borrowing is deemed to be used for the same purpose as the previous debt owing to Miss Take and therefore, the interest is deductible by Newco against the rental income.
Before making this decision, Miss Take and her advisor had a number of things to consider:
• The legal costs of incorporation
• The ongoing accounting costs of the annual tax filings
• The tax rates on the rental income earned inside of the corporation vs. the personal income tax rates (the costs/savings will depend on the province of residence) – this is a key consideration
• The costs of transferring the property to Newco. If legal title to the property is transferred, some provinces charge a transfer tax. In British Columbia, this is often avoided by only transferring the underlying “beneficial interest” and leaving legal title with the original owner. The original owner acts as “bare trustee” for the beneficial owner under a “bare trust” agreement.
These all need to be compared to the savings from the interest deduction.
MNP LLP, Taxation Services