interest deduction from rental income Ask a

Date:           Tuesday February 01, 2005
Time:           10:02 PM -0800
Your Nov/01 Cen-Tapede gives several examples of how to create
interest deductions by associating the borrowing with your business.
In further web searches on this subject I have just found Mohammad v.
Canada (1998) and now I am confused.
My wife and I live in a small city in B.C. We are considering the
purchase of a rental property.  The purchase price would be about
$150,000, annual taxes $1500, monthly rental income $700.  We have
approximately $500,000 equity and a mortgage principal remaining of
$40,000 in our principal residence.
Naturally, the method that was described in your newsletter looked
attractive to us.  If I understand it correctly we should take a loan
for the down payment, then take an additional pre-arranged floating
business loan to pay the mortgage and maintenance costs of the rental
home.  Rental income would be used to pay down the remaining principal
on our principal residence.
In Mohammad v. Canada the court found that interest could be deducted
from the rental income even if the purchase was 100% financed.  Okay,
that I understand.  However, the judge referred to "reasonable
expectation of profit" and in doing so wrote that an acceptable
standard for CRA to apply would be that there can be "no reasonable
expectation of profit so long as no significant payments are made
against the principal amount of the indebtedness".  He goes on in more
detail, but no doubt you are familiar with the judgement so I won't
quote it here.
My question is this:  How do I square that judgement with your method
of financing the rental property, a method that would involve not only
100% financing of the initial purchase price, but additional financing
via the floating business loan.  If I go that route am I likely to
have CRA disallow the whole thing on the basis that I never had any
reasonable expectation of profit?
Looking forward to whatever comments you care to make.
david ingram replies:
You either misread the case or you read the tax court case and missed
the Federal Court of Appeal ruling
The Tax Court disallowed the deduction and the Federal Court of Appeal
allowed the deduction.  However, the question is moot. Further cases
have stated clearly that the concept of "expectation of Profit" no
longer applies if there is no personal use of the item.  Therefore
Expectation Of Profit rules really only apply to the likes of Whistler
Condos, Saltspring cabins and rental sailboats or motorhomes where the
item is used by the owner for personal use as well.
In addition John Singleton LLB won his case for interest deduction in
the Supreme Court of Canada and The CRA issued Bulletin IT 533 which
deals with the issue of deductibility.  The bulletin is quite clear
that you must have a cash flow sheet showing that you "will" make a
"cash flow" profit in the future.
Therefore, having a sheet showing you will lose money for three years
to six years and then start making a profit with a combination of
rental increases and the paying down of the mortgage makes good sense.
Note that capital gains do NOT count as profit for this set of rules.
Following is the  link to the Court of Appeal Mohammad case:
Zahid Mohammad (Applicant)
Her Majesty the Queen (Respondent)
Indexed as: Mohammad v. Canada (C.A.)
Court of Appeal, MacGuigan, Robertson and McDonald JJ.A."Toronto, June
11; Ottawa, July 28, 1997.
The issue was whether the Tax Court erred in refusing to permit the
deduction of interest paid on the $25,000 personal loan.
Held, the application should be allowed.
Taxpayers frequently acquire a residential property for rental
purposes by financing the entire purchase price. The amount of yearly
interest payable on the loan often greatly exceeds the rental income
that might reasonably have been earned. There can be no reasonable
expectation of profit so long as no significant payments are made
against the principal amount of the indebtedness. A rental loss can be
claimed even though no such payment(s) were made in the taxation years
under review, if the taxpayer establishes to the Court's satisfaction
that he had a realistic plan to reduce the principal amount of the
borrowed monies. The taxpayer will discharge that burden by showing
that significant payments were made against the principal indebtedness
in the taxation years closely following the year of purchase. The
application record referred to such payments having been made, but
evidence thereof was not before the Tax Court Judge and was not raised
during this hearing.
Make out a cash flow sheet showing eventual rental cash flow profits
and sleep well.
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