Real Estate

Leveraging equity in rental property to invest - tax implications

  • Last Updated:
  • Jun 23rd, 2021 1:03 am
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Jun 22, 2021
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Leveraging equity in rental property to invest - tax implications

The example below illustrates an income-splitting technique whereby one spouse 'lends' money to another spouse at the legally prescribed rate so that gains made by the lower-income spouse are taxed at a lower tax bracket. After reading the example, there's a question and hoping someone can provide any insight:

Example for Ontario residents:
  • Mr. A earns employment income of $80,000 per year.
  • Mrs. A earns $34,000 per year.
  • Mr. A has accumulated savings of $100,000, he and Mrs. A have no debt, he has used his maximum RRSP contribution room, and he would like to purchase investments outside of RRSPs.
  • Mr. A lends the $100,000 to Mrs. A on January 1, 2012.
  • A promissory note is written up, specifying that the loan is made at the current prescribed interest rate of 1%.
  • Mrs. A invests the $100,000 in Canadian stocks yielding 10% (3% dividend, 7% capital gain).
  • Canadian dividend income of $3,000 in 2013 is reported by Mrs. A on her 2012 tax return, which equates to $4,140 of taxable income because Canadian dividends are grossed-up by 38% to include in income. The dividends are eligible for the enhanced dividend tax credit.
  • Mrs. A pays $1,000 (1%) interest expense to Mr. A on December 31, 2012. This interest expense is deducted on line 221of Mrs. A's 2012 tax return.
  • Mrs. A's taxable income is $37,140 (34,000 + 4,140 - 1,000).
  • Mr. A includes the $1,000 interest income on line 121 of his 2012 tax return.
  • Mr. A's taxable income is $81,000 (80,000 + 1,000).
  • $360 in tax is saved by Mrs. A investing the $100,000 instead of Mr. A, assuming the Canadian stocks are not sold.
  • If the Canadian stocks are sold at the end of 2012 and 7% capital gain realized, $954 in tax is saved due to Mrs. A having the capital gain ($3,500 taxable) and dividends instead of Mr. A.

QUESTION - if the $100K that Mr A lends to Mrs A is from a cash-out refinance from a rental property, is the interest he's paying on that portion of the mortgage tax deductible now that he is lending the money to Mrs. A and receiving an 'income' on the $100K (1%). The tax law states that the interest is deductible on 'income' investments, not capital gains; does the loan to Mrs. A where 1% is being charged, count as an 'income' investment thus making the interest on the mortgage tax deductible?
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