By Keith Vincent
Last week you were presented the story of Miss Take. We continue the discussion on the second condition to provide tax deductible interest.
The Bulletin states that “the test to be applied is the direct use of the borrowed money. In certain circumstances, however, the courts have stated that indirect use will be accepted as an exception to the direct use test.
In determining what borrowed money has been used for, the onus is on the taxpayers to trace or link the borrowed money to a specific eligible use, giving effect to the existing legal relationships.”
Applying this “trace or link” test to Miss Take’s situation it’s clear that the borrowed funds were used to purchase her new principal residence. The fact a rental property was used as collateral for her loan is of no consequence. She clearly used the borrowed funds to purchase her new principal residence and, as we all know, interest paid on debt incurred to purchase a principal residence is not deductible for income tax purposes. The end result for Miss Take will be taxable rental income and non-deductible interest expense. The problem here is the taxpayer has confused the security for the new borrowing with the use of the borrowed funds. In this case, the security for the loan does not matter – it’s the use of the borrowed money that counts.
Consider the approach taken by Rita Ohn who has paid-off her existing home and now wants to buy a new home and commence renting her own home. Knowing the importance of “tracing” in the deductibility of interest, Rita took the following steps, in order, and at fair market value:
On day one, Rita sold her current home (the “old home”) to her parents for fair market value. Rita’s parents paid for the purchase by issuing a promissory note to Rita. Always concerned about property transfer tax and other matters, Rita discussed this series of transactions with her lawyer who ensures all steps are properly documented.

1. On day two, Rita reacquired the “old home” from her parents by borrowing from the bank on the security of a mortgage.
2. Rita plans to use the “old home” as a rental property;
3. Rita’s parents use the funds received to repay the promissory note they issued to Rita on day one; and
4. Rita then uses the funds received from her parents to purchase her new home.
When the dust settles, Rita owns a rental property (the former “old home”) and she also owns a new home. Following the “tracing” principle Rita can clearly show that the money she borrowed was used to purchase a rental property and, therefore, the interest paid should be deductible against the rental income she receives in the calculation of her taxable income.
This example shows that a few simple steps can result in a very different outcome.

Keith Vincent
MNP LLP, Taxation Services