Loan interest is still deductible on your tax return, even if your investment or business goes bankrupt

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If you borrow money for the purpose of earning investment or business income, the interest you pay on that debt is generally tax deductible. But what if your investment turns out to be a dud and drops to zero – or you’re forced to close your business – while you still owe money on your loan? Should interest continue to be tax deductible long after the original source of that income has disappeared?

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Fortunately, the answer comes in the form of a little-known rule in our Income Tax Act, sometimes known as the “loss of source” rule. The rule, in effect since 1994, applies when borrowed money no longer has the potential to generate income because the source of that potential income has disappeared. The rule therefore essentially allows you to continue deducting previously deductible interest expenses, even after the source of the investment or business income has disappeared.

I have often referred to this rule in the context of investing as the “Bre-X rule”, named after the infamous mining company that went bankrupt. For example, suppose you borrowed funds in the mid-90s to buy shares of Bre-X. The company, which started as a penny stock and peaked at nearly $300, went bankrupt in 1997 after a massive fraud involving falsified gold samples was uncovered. Well, the silver lining – pun intended – is that if you had borrowed to invest in Bre-X stock and that loan was still outstanding today, you could still write off your interest charges because the funds were originally borrowed for the purpose of earning investment income.

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The loss of source rule with respect to a business emerged recently in a tax case involving a Montreal accountant who deducted $2,750 and $2,555 in interest expenses on his tax returns in 2013 and 2014, respectively. . From 2002 to 2007, the taxpayer was self-employed and operated a business that provided accounting services in the communities of Brossard and Trois-Rivières. In 2007, he joined his company. During the years covered by the CRA (2013 and 2014), the taxpayer was employed as a lecturer in the accounting departments of three Quebec universities.

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The interest expense for the years in question arose from various expenses that the taxpayer incurred for his business during the 2002 to 2006 taxation years. These expenses, which included rent, software subscriptions, telecommunications, professional dues , insurance, supplies and travel, totaled $93,545.

These business expenses were all paid for by checks drawn on his home equity line of credit (“HELOC”), which was used exclusively for business purposes. In other words, he used his HELOC from March 2002 to December 2005 only to pay disbursements related to his accounting firm which he operated as a sole proprietorship.

After that date, the HELOC was used only to repay the interest charged by the bank. While the HELOC was also in his wife’s name, it was done “for the simple reason that she was co-owner of the family home”.

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The taxpayer ended up in Tax Court because the Canada Revenue Agency disallowed the interest charges he had claimed in 2013 and 2014. At trial, however, the CRA acknowledged that two-thirds of expenses charged to the HELOC from 2002 to 2005 were likely incurred for the purpose of earning business income, but began to question the validity of some $21,000 of travel expenses for which the taxpayer had “a lack of supporting documents”.

But the judge said nothing about it, saying that the taxpayer “did not have to justify the deductibility of the expenses for tax purposes, because they were deducted in the calculation of (his) income for the tax years. 2002 to 2006 and were (previously) authorized by the CRA. The only issue (today) was whether the (taxpayer) could deduct the interest expense he incurred after ceasing to carry on his business personally.

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The taxpayer argued that he should be entitled to continue to deduct the interest expense on the loan even though the business had ceased operations, since the loan continued and the interest continued to be paid. He argued that under the loss of source rule, “borrowed money is deemed to be used by the taxpayer for the purpose of earning income from the business, and that this (rule) therefore permits deduct interest paid on borrowed money. ”

The judge reviewed the facts and found that as of December 2, 2005, the date of the last expense charged to the HELOC, the amount borrowed from the HELOC totaled $91,615. Thereafter, from 2006 to 2014, only accrued interest on the HELOC.

The judge then turned to the loss of source rule, which clearly provides that the portion of borrowed money that is unpaid when a business ceases operations “shall be deemed to have been used by the taxpayer at any subsequent time in purpose of earning income from the business. .”

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The judge therefore concluded that the conditions for the application of the loss of source rule were met and that, therefore, the borrowed money that was unpaid when the taxpayer’s business ceased its activities “will be deemed to have been used by the (taxpayer) during the 2013 and 2014 taxation years for the purpose of earning income from the business. Therefore, the taxpayer was entitled to deduct 100% of the interest expense he claimed for the 2013 and 2014 tax years.

Jamie.Golombek@cibc.com

Jamie Golombek, CPA, CA, CFP, CLU, TEP is Managing Director, Tax and Estate Planning at CIBC Financial Planning and Advisory Group in Toronto.