Many real estate investors assume that if a mortgage is registered against a rental property, the interest automatically becomes tax-deductible.
Unfortunately, that’s not how the Canada Revenue Agency (CRA) looks at it.
This question often comes up when someone owns both a principal residence and a rental property. The principal residence still has a mortgage, while the rental property is mortgage-free. Naturally, the owner may wonder:
“Can I refinance the rental property, use the money to pay off my home mortgage, and then deduct the interest against my rental income?”
At first glance, this seems reasonable – after all, the new mortgage would be secured by the rental property. But for tax purposes, the key issue is not which property is used as collateral.
The key issue is: what were the borrowed funds actually used for?
CRA’s General Rule
For interest to be deductible, borrowed money must generally be used to earn income from a business or property. This is often called the “use of borrowed funds” test.
In simple terms:
- If borrowed money is used to buy or improve a rental property, the interest may be deductible.
- If borrowed money is used to buy investments expected to earn income, the interest may be deductible.
- If borrowed money is used for personal purposes, the interest is usually not deductible.
CRA traces the borrowed funds and looks at where the money actually went – not what it’s secured against.
Example
Say a taxpayer owns:
- a principal residence with an outstanding mortgage; and
- a rental property with no mortgage.
The taxpayer refinances the rental property and uses the borrowed money to pay off the mortgage on their principal residence.
Even though the new loan is secured by the rental property, the borrowed funds were used to repay a personal mortgage. As a result, the interest would generally not be deductible against rental income.
Why the Security for the Loan Isn’t Enough
Many people focus on the property used as security. CRA does not.
A rental property can be pledged as collateral for a personal loan, but that doesn’t make the interest deductible. The tax result depends on the use of the money, not the asset pledged to the bank.
If CRA reviews the transaction, they’ll typically ask for:
- refinancing documents;
- bank statements;
- mortgage payout records;
- proof of where the borrowed funds were deposited; and
- evidence showing how the funds were used.
If the money can be traced to the repayment of a principal residence mortgage, CRA will generally treat the interest as personal and non-deductible.
What Do the Courts Say?
Canadian case law backs up CRA’s approach – and adds two distinct pieces to the test.
Singleton v. Canada (2001 SCC 61) established that deductibility turns on the actual, traceable legal use of the borrowed funds -not on the taxpayer’s overall financial position or intentions.
Ludco Enterprises Ltd. v. Canada (2001 SCC 62), decided the same day, added that the funds must also be used with a purpose of earning income – even if that purpose is only ancillary to some other goal.
Together, these cases form the “tracing” framework CRA applies today: trace where the money went (Singleton), then confirm it was put toward earning income (Ludco). Repaying a personal mortgage satisfies neither test.
It’s also worth knowing that some taxpayers have tried to get around this by using carefully structured, simultaneous transactions to convert personal debt into deductible debt. Even when technically well-structured, this kind of planning can still be challenged and denied by CRA under the General Anti-Avoidance Rule. It’s not a do-it-yourself strategy – it requires professional advice before any money moves.
When Interest May Be Deductible
Interest may be deductible when borrowed funds are used for income-producing purposes, such as:
- purchasing a rental property;
- renovating or improving a rental property;
- buying equipment or assets for a business;
- purchasing income-producing investments;
- refinancing an existing loan that was originally used for income-producing purposes.
When Interest Is Usually Not Deductible
Interest is usually not deductible when borrowed funds are used to:
- pay off a mortgage on a principal residence;
- buy a personal-use property;
- pay personal living expenses;
- fund vacations, vehicles, or other personal purchases;
- consolidate personal debt.
What About a HELOC?
A HELOC can be a useful planning tool, but the same rule applies.
- If a HELOC is used to invest in income-producing assets, the interest may be deductible.
- If a HELOC is used to pay off a personal mortgage or personal expenses, the interest is generally not deductible.
Again, the issue isn’t the type of loan – it’s the use of the borrowed money.
Refinancing a rental property to pay off a personal home mortgage may improve cash flow or borrowing terms, but it does not automatically create a tax deduction.
Before claiming interest as a rental expense, confirm that the borrowed funds were actually used for an income-producing purpose. Incorrectly claiming personal interest as a rental expense can result in CRA denying the deduction, reassessing the return, and charging arrears interest.
On a Final Note….
Debt restructuring can be a valuable tax-planning tool when done correctly – but the details matter. Before refinancing, speak with a tax professional to confirm whether the interest will actually be deductible and how the transaction should be documented.
This article is intended for general informational purposes only and does not constitute tax, legal, or financial advice. Every situation is different . Please contact Piligrim Accounting Inc. to discuss how these rules apply to your specific circumstances.
