INVESTMENT INTEREST DEDUCTIBILITY – BEWARE OF ATTRIBUTION
Ryan Sahota, CPA, CA | Wednesday, September 28th, 2016
As we head into the fall season and finalize investment and tax planning for the current year, you should have a good chat with your accountant about a certain set of tax rules called the Spousal Attribution Rules. This past summer season I spent time with some new clients, a lovely couple who we shall call John and Mandy, going over their personal income tax returns and the denial of interest deductibility on funds loaned to purchase qualifying investments by the Canada Revenue Agency (CRA). The issue, was that John had been reassessed by the CRA and was not able to claim the interest on the funds used from his line of credit to purchase qualifying investments.
In the past, John would normally contribute to Mandy’s RRSP through spousal contributions, once these were maxed out he would purchase additional investments for her in a regular account. John had traditionally been the sole income earner in the household and wanted to register investments under Mandy’s name so that any future capital gains or income generated would be taxable under her name as she was in a much lower tax bracket. In the last two years, taking advantage of the low interest rates, he had taken out loans from their joint line-of-credit secured by their house to purchase additional investments and placed them under Mandy’s name.
For simplicity sake, normally you are allowed to deduct the interest incurred on funds borrowed on investments purchased with the intent to earn income from these investments. However, in John and Mandy’s case, John had purchased investments for Mandy under a joint line-of credit secured by their house and deducted the associated interest on his tax return. This is where the Spousal Attribution Rules come into play.
The Spousal Attribution Rules very simply “attribute” taxable income earned by a spouse back to the spouse who gave the funds to use for the purchase of income producing investments or property. In this case a joint line-of-credit was secured by John and Mandy’s home as collateral, and John provided the guarantee to repay all or part of the line-of-credit should a default happen. If such a guarantee is provided, the Income Tax Act deems the loan was made to the borrower (Mandy) from the person offering the guarantee (John), which means that the attribution rules will kick in. With these rules, any future income or capital gains from the investments would be attributed back to John even though they are in Mandy’s name. To add further pain, John cannot claim the interest deduction as legally the shares are under Mandy’s name.
There are exceptions to the general rule above where the interest would be deductible by Mandy, unfortunately in her case there would be no benefit as she has no taxable income. To make matters worse there would never be any interest deductibility for John in this type of arrangement and he would still be attributed and taxed on the additional income from the investments in Mandy’s name.
Sitting down with John and Mandy in late December they were shocked to find out that the interest was not eligible to be deducted in John’s name and that any income realized was to be taxed under John, resulting in a hefty tax bill. John mentioned to me that he had gained this advice from his financial advisor and that the majority of his friends were utilizing the same strategy. I explained that unfortunately a good number of individuals and advisors who were using these methods had not yet been scrutinized by the CRA and normally would not be aware of the Attribution Rules as they are not general knowledge. When considering the use of joint lines of credit or equity from a mortgage for investment purposes, it is a good idea to consult a designated tax professional to ensure that your investments and objectives align with the Income Tax Act. If you are currently participating in this type of arrangement, be proactive and keep detailed records to prove borrowing and repayment histories and seek the advice of a tax professional before it’s too late.