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Borrowing To Invest
Generally, borrowing costs for investment purposes are fully deductible. For fixed income securities, the interest paid is fully deductible up to the rate yielded by the security.
For example: If funds are borrowed at 8% and used to purchase a bond paying interest at 7.5%, then the interest expense deduction is 7.5%. If the funds are used to purchase a preferred share with a dividend yield of 6.4%, the maximum interest expense deduction is 6.4% x 1.25 (dividend gross-up) or 8%.
For common shares, interest paid on a loan that is used to purchase the securities may be fully deductible, even though the grossed-up dividends may be less than the borrowing rate on the loan.
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Interest Deductibility
When you borrow funds to purchase investments, the interest is only tax deductible as long as you continue to hold the investment or any substituted investment. You can change the actual investment held but all of the borrowed funds must be invested in income-generating investments.
There are special exceptions to the rules related to tax deductions on interest costs designed to provide relief to investors who have borrowed money to buy investments that have since declined in value. This allows you to continue to deduct the interest expense on the loaned funds after the sale of the investment subject to certain restrictions, illustrated by the following:
- If an investment is sold at a loss and the proceeds are used to purchase another investment, the interest paid on the original investment loan will still be fully deductible.
- If the investment is sold at a loss and the proceeds are not used to purchase other investments, the proportion not reinvested will not be deductible.
- If instead of selling the investment, you gift it to another family member, or transfer it to a RSP, then that proportion of the interest expense related to the transferred investments will not be deductible for tax purposes.
These rules do not apply to investments in real or depreciable property. The rules relating to loans used to finance businesses are more complex, so please consult your tax advisor.
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