Here are some tax planning tips of making the most of your interest expense write offs.
There are three tests you must meet in order to deduct the interest on borrowed money.
- There must be a legal obligation to pay the interest. This can become an issue with family loans when the obligation to pay the loan and interest is not in writing.
- The borrowed money is used for the purpose of earning income from a business or property.
- The interest paid must be reasonable. This reasonableness test is met when the rate charged is close to the interest payable on a loan between an arm’s-length borrower and lender.
If you take out a loan to purchase investments which generate interest, dividends or capital gains, then the loan interest is fully tax deductible.
Suppose you own a $100,000 investment portfolio. You want to borrow $100,000 for personal use. The interest is not deductible because it is not used to generate income. What you can do, is sell the investments and use the cash for personal use. You can then borrow the funds to purchase the investment and of course the interest is deductible. By doing the swap, you have now converted a non-deductible personal debt into a deductible investment loan.
Suppose you live in a condo worth $700,000 with a mortgage of $200,000, and you plan to purchase a home for $1.5m and keep the condo as a rental property.
You sell the condo for $700,000 to your corporation. The corporation assumes the $200,000 mortgage and borrows an additional $500,000 to pay for the condo in full. The interest on the $700,000 debt is deductible as a corporate expense. You are getting the $500,000 tax–free for the down payment on your new home.
Suppose you borrowed $100,000 to purchase a $100,000 investment. You sell it for $60,000 and you take the money for personal use. You still owe the full $100,000. Although you sold the investment, you can still deduct the interest expense on $40,000 of the loan. The remaining loan is not deductible, because you used the funds personally.
Here is an exception to the rule that a loan must be used for income earning purposes for the interest to be deductible.
You can borrow money personally and lend it your professional corporation at no interest. This interest free loan means that you can fully deduct the interest on your personal tax return without having to report any interest income on the loan. A nice tax shelter!
