Wednesday, February 24, 2010

TAX TIME SHOULD MEAN MONEY IN YOUR POCKET



How your mortgage can lower your tax bill
You can deduct mortgage interest without getting in trouble with the taxman

James Pasternak, Financial Post
Published: Monday, February 22, 2010


When Toronto resident Celia Bernath files her annual income tax return, she includes a long list of deductions from her home-office income. After all, as a chartered accountant, she knows that travel, bank, postage, courier, utility and other charges and expenses are fair game for the micro-entrepreneur. But the item that sometimes has the most impact is deducting a proportion of her residential mortgage interest.

"The mortgage-interest deduction - like other deductions - is based on the square footage of my office divided by the total square footage of the house. Keeping track of all your household expenses is very important," says Ms. Bernath, who has about 15 corporate and 100 personal clients.

Ms. Bernath is one of the more than 700,000 home-based business owners who might be eligible to deduct a portion of their mortgage interest on their principal residence as an expense.

Generally speaking, in Canada, interest on residential mortgages is not tax deductible.

However, Ms. Bernath can do so because there is a direct link between the borrowed money and earning income.

"The long and short of it is if you want to be able to deduct interest on your mortgage, the loan has to be incurred for business purposes," says Yens Pederson, a partner with the Regina law firm of Balfour Moss LLP.

Canadians like to talk about mortgage-interest deductibility because the mortgage on a principal residence is the biggest debt Canadians have. They also like to talk about it because tax laws in the United States have provisions for residential mortgage-interest deductibility. Far fewer realize that Americans must pay a capital gains tax when they sell their home.

But beyond the fairly straightforward deductions of mortgage interest, the political machinations and bookkeeping shenanigans have made the mortgage-interest debate a colourful one in Canada.

Many say that the promise of mortgage-interest deductibility put the Conservatives in power and made Joe Clark prime minister in 1979. The Clark government was gone within nine months and the legislation was never enacted.

In 2003, the Conservative Party of Ontario announced that if re-elected it would pass legislation allowing homeowners to deduct $5,000 of their mortgage-interest payments from their taxable income, resulting in up to $500 in savings for homeowners. The party was defeated in the next provincial election.

Between these political attempts to liberalize mortgage-interest deductibility, the federal government moved to restrict tax avoidance strategies. In 1988, Parliament enacted the general anti-avoidance rule (GARR) to curb so-called "abusive" tax avoidance.

Under its most common allowances and interpretations, mortgage-interest deductions can still work as an effective strategy for reducing taxes. In addition to the case of a home business, one can deduct mortgage interest when investing in a residential rental property.

"If you are purchasing a property and you take a mortgage to purchase that property and then you rent out that property, then you are getting rental income from it," said Todd Trowbridge, a partner of Toronto-based accounting firm Trowbridge Professional Corp. "That interest would be deductible. There always has to be an earning income use of the funds."

Take the case of Toronto resident Howard Frank who invested just more than $400,000 in a 2,400-square-foot residential rental building with three units in May 2007. Mr. Frank took out a $300,000 mortgage, paying 5% interest. So in addition to a wide range of other deductible expenses such as property tax, maintenance, any utilities, insurance, administrative and legal fees, Mr. Frank deducts $15,000 in interest payments against the $33,600 in rental income.

A similar mortgage-interest deduction opportunity exists when one is renting out a room in one's principal residence or is earning income from a vacation property for all or part of the year. In both cases, the arrangement must be a legitimate commercial agreement.

"If you rented [the vacation property] out below value to family it would probably be offside. If you rented it out to third parties at a reasonable rate [the Canadian Revenue Agency might] look to see whether there was any commercial reality. At the very least you could deduct it off the rental income for the portion of time it was actually rented," says Mr. Trowbridge.

Some deduct mortgage interest through "the Smith manoeuvre" as promoted by Victoria, B.C.-based former financial strategist Fraser Smith. In its simplest terms, the homeowner pays down the mortgage as quickly as possible, creating small amounts of equity each month.

The equity is simultaneously filled with a line of credit to be used for investment purposes. The interest on the growing investment loan is deductible.

"Instead of giving it to the bank for making mortgage payments we can then invest it in ourselves and build our investment portfolio," says Mr. Smith, 71, who has sold 53,000 copies of his book Is Your Mortgage Tax Deductible?

"You deduct the interest on the investment loan. In the end, if you started with a $300,000 mortgage, you will end up with a $300,000 investment loan. So you'll be deducting the interest on the $300,000 for the rest of your life."

One way to deduct mortgage interest without actually paying the interest is through a reverse mortgage. The reverse mortgage allows a homeowner to tap into the equity of his or her home without having to pay interest or principal on the loan. The loan is satisfied on the death of the home owner or the selling of the home. Therefore, when the proceeds are invested, the homeowner can deduct interest charges against investment income, without actually paying the interest.

"CHIP Home Income Plan interest expenses may be used as a deduction to offset, in part or entirely, income tax liability generated by investments - as long as those investments were purchased with CHIP proceeds," says Arthur Krzycki, director or marketing and public relations at reverse mortgage specialist HomEquity Bank.

Mr. Krzycki says that if one invests a $100,000 reverse mortgage at current rates, the interest expense will be about $3,750. If one has an investment that earns a 3.75% return in the same time period, the two amounts will offset. So, the 3.75% investment income appears to be "tax free" for cashflow purposes, while the interest expense is added to the outstanding balance of the reverse mortgage.

An even more creative application of mortgage-interest deductibility came in the late 1980s. John Singleton, a partner in a law firm, tested current mortgage-interest deductibility rules by withdrawing $300,000 from his partnership capital account to purchase a house. Mr. Singleton then mortgaged the house by borrowing $298,750 from the bank and depositing the money into his partnership account, along with $1,250 of his own money.

When the time came to do his tax return, Mr. Singleton deducted $3,688 of interest on his 1988 tax return and $27,415 on his 1989 return. Mr. Singleton argued the borrowed funds, not the withdrawn funds, were used for investment purposes.

The deduction was originally challenged by Revenue Canada, as the taxman was then called, and after the case wound its way through the courts Mr. Singleton finally won the day.

"The court effectively looks at the direct use - the form of the transaction - and does not consider economic substance," says Daniel Sandler of Toronto-based law firm Couzin Taylor LLP. "So, by the same token, if a taxpayer cannot demonstrate that the direct use of the borrowed money was an income-earning purpose, the interest will not likely be deductible."

By January 2009, the Supreme Court of Canada sent a signal that it was open to creative applications of mortgage-interest deductibility, but not financial shenanigans. The case in question dates back to 1994, when the Lipsons, a husband-and-wife team, entered into an agreement to buy a home. Ms. Lipson borrowed $562,500 from a bank to buy shares from Mr. Lipson in a family investment company. The couple then obtained a mortgage from a bank for $562,500, using the funds to repay the share loan in full. In his 1994, 1995 and 1996 tax returns, Mr. Lipson deducted the interest on the mortgage loan and reported the taxable dividends on the shares as income where it was applicable.

"In essence, the majority of the court allowed the interest expense, but in the hands of Mrs. Lipson not Mr. Lipson. According to the majority, the interest-expense rule was not the rule that was abused in the case; it was the attribution rule," says Mr. Sandler.

Recently, a more liberal interpretation of mortgage-interest deductibility has emerged. In November, 2009, the Tax Court of Canada ruled in the case Henkels vs. The Queen, that expenses deducted from rental income in a private residence do not have to be directly tied to the square footage used by the tenant. The Henkels rented 700 square feet of space to a tenant, which is only 35% of the square footage of their home, but deducted 50% of the acceptable household expenses because the tenant had access to the entire house.

"This case reinforces the position that you could measure expense deductibility on a reasonable basis other than square footage," says Marc Weisman, a tax lawyer at the Toronto-based firm of Torkin Manes LLP.

As for Mrs. Bernath, she takes the more cautious approach, sticking with existing standards. "[The ruling] does allow you the opportunity to deduct more," she says. "It is good to be aggressive but being too aggressive gets you a nasty invitation from CRA."

"Yes," says Mrs. Bernath, "walk on the grey line [but] ensure that your expenses can be justified."

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