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Lines of Credit And Interest Deductibility

Popular perception, backed up by a recent Statistics Canada report, indicates that Canadians are turning increasingly to the use of credit as a financial tool. Nowhere is that trend more apparent than in the tremendous growth in the use of lines of credit, most often secured by the equity in a family home. As of 2005, according to StatsCan figures, almost a quarter of Canadian families owed money on a line of credit.

The uses to which a line of credit can be put are, of course, virtually endless. In some cases, taxpayers may want to take advantage of both relatively low interest rates and increased home equity arising from a strong real estate markets to participate in a rising stock market. In other cases, available credit may be used to finance personal acquisitions - the big-screen TV or a last-minute winter vacation. And, of course, it's entirely feasible to use the same line of credit for both personal and investment purposes.

Where interest charges are incurred on a line of credit, the rules respecting the deductibility of such interest are the same as interest paid on any other type of debt. That is, interest is deductible only to the extent that the borrowed money is used for the purpose of earning income from a business or from property. In interpreting that rule, the courts have held that it is the direct use to which the funds are put which determines the deductibility of the related interest. Further, the onus is on the taxpayer to trace funds to a current eligible use. Notwithstanding the strictness of the direct use rule, a recent Canada Revenue Agency technical interpretation indicates that taxpayers may have some latitude in computing deductible interest costs incurred where a line of credit is used for both personal and investment or business purposes.

The hypothetical situation put to the CRA involved a taxpayer who had a personal line of credit with a balance of $60,000 on January 1. During that month, the taxpayer increased the balance on the line of credit to $100,000, borrowing the additional $40,000 to invest in securities (an eligible use). On February 1 the taxpayer made a payment of $20,000, bringing the balance down to $80,000, where it stayed throughout the month Another payment, this time of $40,000 was made on March 1, bringing the balance down to $40,000, where it remained throughout the month. The taxpayer suggested to the CRA that his interest deduction for the line of credit for the first three months of the year would look as follows:

The CRA agreed with the taxpayer's views on the percentage of interest deductible for each month. The CRA's position is that where borrowed money and other money are commingled (for example, in a bank account), the taxpayer can choose the uses of the borrowed money from all of the uses of the money. In other words, if the taxpayer can demonstrate that the aggregate eligible expenditures (i.e. those incurred for the purpose of earning income from a business or from property) from a commingled account exceed the amount of borrowed money deposited to that account, the CRA will generally agree that the taxpayer has satisfied the test of tracing borrowed funds to an eligible purpose. In the Agency's view, a similar approach, as in the above example, would apply to borrowings on lines of credit and similar financial instruments, as long as the borrowed funds continued to be put to an eligible use.

The CRA's position means that, where a line of credit is used for both business and non-business (or, more technically, eligible and non-eligible) purposes, the percentage of interest paid on that line of credit each month which may be deducted for tax purposes will be equal to the proportion that the funds used for eligible purposes is of the outstanding balance. Given the proliferation of lines of credit as a financing source, that will come as welcome news to a substantial number of Canadian taxpayers.