Thinking of borrowing to invest? Let’s see some of the concepts of investment loans and how they affect your tax return.
If used properly, investment loans can be a tax effective way to grow your nest egg. As with any case with investment loans, remember that borrowing to invest is a very risky proposition. This article will attempt to explain how these loans are handled on the tax return, and give you certain strategies that you can use.
Are investment loans deductible on my tax return?
Yes! The principal of the loan is not tax deductible, but rather the interest you pay on the loan. But as with anything on the tax return, there are conditions! The loan you take out to invest has to produce what the CRA considers as “investment income”, which includes interest and dividend income. So you can borrow money to get GICs or bonds, and the interest expense becomes tax deductible. You can also use the borrowed funds to buy stocks and deduct the interest expense; however, these stocks have to be dividend payers; no speculative penny stocks allowed!
Are investment loans for RRSP and TFSA contributions deductible?
No. Because the investments you hold in these plans are tax sheltered, the CRA does not allow you to deduct the interest from these loans. It doesn’t mean you shouldn’t borrow to invest in these plans though! Investment loans for RRSP contributions could make sense depending on your tax rate. The higher your tax rate, the more sense it makes to take out a loan. Let’s look at an example:
John has gained $60,000 during the year. John has $5,000 to invest in his RRSP, but has a lot of space in his RRSP deduction limit. He is wondering if he should borrow another $5,000 and add it to his contributions to start using up this limit. At $60,000, John is in the 22% tax bracket federally. If he were to invest the $10,000 into his RRSP, he can claim this amount as a deduction on his tax return, and he would reduce his taxes by roughly: $10,000 X 22% = $2,200. John can now grab that $2,200 and pay off a good portion of his RRSP loan. This approach is commonly referred to as a “catch-up” loan.*
*This example does not consider the provincial effect of using the extra $5,000 as an RRSP deduction, which would increase the tax reduction in the example above.
From the example above, we see how borrowing to invest in an RRSP can have benefits. For one, we can pay off a good chunk of the loan right away through the tax refund. Another benefit is that the amount invested can start working for you sooner.
Borrowing to invest in a TFSA is less advantageous short term compared to an RRSP, due to the fact that you don’t get the immediate effect of the tax deduction on your return. However, in the longer term, it can get more advantageous for a TFSA loan due to the fact that the future withdrawals will be tax free.
Is my mortgage interest tax deductible?
Yes under certain conditions. In general, mortgage interest is deductible only if you used the loan to gain income from a property, such as a rental property. The interest of the mortgage is deducted from your gross rental income as an expense.
In other words, interest paid on the personal portion (the part of the house you live in) of your residential mortgage is normally not deductible. However, there is one method that allows you to still deduct it on your tax return. This method consists of converting your mortgage into an investment loan that you will use to buy investments other than rental properties (stocks, bonds, GICs). You can accomplish this by using what is called a "re-advancable mortgage".