The article “Are interest payments tax deductible?” was originally published in MoneySense on August 9, 2021.  Photo by Photo by Windows on Unsplash.

Interest paid may be tax deductible under the right circumstances. Find out which scenario might apply to you.

Taxpayers may be eligible to claim a tax deduction for interest paid on a loan or mortgage. According to Canada Revenue Agency (CRA), “most interest you pay on money you borrow for investment purposes [can be deducted] but generally only if you use it to try to earn investment income.”

One common example is money borrowed to buy stocks, bonds, mutual funds and/or exchange traded funds (ETFs). This interest can generally be deducted on a taxpayer’s line 22100 as an interest expense. However, there are a few caveats.

According to the CRA, “if the only earnings your investment can produce are capital gains, you cannot claim the interest you paid.” What other earnings would qualify? Well, most stocks pay dividends. Most bonds pay interest. Mutual funds and ETFs generally earn dividends, interest, or a combination of the two. (Note: In Quebec, you can only deduct your interest up to the amount of income generated by an investment. In other provinces and territories, you can generally claim your interest, even if it exceeds the income generated.) An example of when interest may not be tax deductible is when you buy land that does not produce rental income and can only produce capital gains. Buying a stock that has no history of paying dividends (or the class of shares does not allow dividends) is another potential example.

Here are a few more situations that would result in tax deductible interest for a taxpayer.

When interest payments may be tax deductible—and when they’re not

You have loans for non-taxable accounts

If money is borrowed to invest in a non-taxable account, like a registered retirement savings plan (RRSP), that interest isn’t tax deductible either. Loans for RRSPs are common, and the lender may even provide an interest statement or summary at year-end. However, that interest isn’t tax deductible because RRSP income is tax deferred. Since it is not taxable investment income, the corresponding interest cannot be deducted. The same logic applies for money borrowed to invest in a tax-free savings account (TFSA)— the resulting interest is not tax deductible either.

You have rental properties

Interest paid on money borrowed to buy a rental property is generally tax deductible on form T776 of your tax return. This would commonly include a mortgage on a rental property. There are a couple of points to consider on rental property interest as well.

If you borrow money secured by your home or another property to buy a rental property, even though the debt is not secured by the rental property itself, the interest would generally still be tax deductible. It is the use of the funds that matters, not the property itself, that determines tax deductibility.

Similarly, if you borrow money secured by a rental property–say, using a rental property line of credit or by increasing the mortgage–the use of those funds is key. The interest is not tax deductible simply because the debt is on a rental property. If you use a rental property line of credit to buy a new car, the interest on that portion of the debt is not tax deductible. A car is a personal use for the borrowed funds and not an investment that can produce investment income.

You’re self-employed

Those who are self-employed may also be able to claim a portion of their home mortgage interest on Form T2125 if they work primarily from a home office. If someone is an employee who primarily works from home, mortgage interest is only deductible on Form T777 if some or all of their employment income is commission income (so, not if they are simply a salaried employee).

You took a loan against a life insurance policy

A life insurance policyholder who takes a policy loan to generate income from property or business may also be able to deduct that interest. A borrower needs to have the insurance company complete Form T2210, Verification of Policy Loan Interest by the Insurer.

You have school loans

Student loan interest is not tax deductible, but it may be eligible to claim on line 31900 of your tax return as a non-refundable tax credit.

A case for separating personal and tax deductible debt

Borrowers who mix personal and tax deductible debt need to be careful. Ideally, you should keep your debts separate to avoid confusion. Many lenders allow you to separate mortgages or lines of credit into multiple accounts to allow for easier tracking. If you have a single debt that is used for both personal and investment purposes, the CRA may consider your repayments to go against your tax deductible debt first instead of your personal debt – even though a taxpayer may prefer the opposite.

If an investor disposes of the investments they bought with borrowed money or uses the investments for other purposes like to fund a RRSP or TFSA contribution, or for personal use, the tax deductibility of their debt may need to be reduced on a pro-rata basis.

Money borrowed for business purposes–whether for a sole proprietorship, partnership, or corporation–may result in tax deductible interest.

Is interest paid on a recovered tax refund deductible?

If a taxpayer received interest on a tax refund in the current or a previous tax year that was reversed due to a change to their tax return, that may result in a tax deduction. Repaid refund interest is considered tax deductible interest in the year of the reassessment. Similarly, refund interest paid is considered taxable income in the year it is received.

In summary, there are plenty of situations when interest is tax deductible (or even eligible for a tax credit). It is important to ensure that you are correctly deducting and tracking your interest to properly file your tax return and avoid any surprises in the future.

Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto, Ontario. He does not sell any financial products whatsoever.