Skip to content

Understanding Deductible Debt – How to Decide What Debt to Pay Down First and How to Create a Bigger Tax Deduction



In today’s expensive world, many of us need to pinch pennies to make ends meet.  When times are tight, it may seem like the only way of balancing the books is finding a new job or scaling back your Starbucks addiction.  While it still might come to this, there may be some other steps to consider that may allow you to continue enjoying your double chai latte without having to dust off your resume; tax planning can put money back  in your pockets and maximizing your deductible interest  may be a big contributor to this refund.

To begin, I will highlight the potential tax benefits of increasing your deductible interest.  I will then try to explain the hoops you must jump through in order to make your interest expenses fully or partially tax deductible.  Finally, I will talk about a few strategies you might consider to keep you in the java going forward.  I also plan on writing some future articles on some of the more advanced strategies, like Cash Damming or the Smith Maneuver.

Basic Principles

In a nutshell, writing off your interest expenses reduces the real cost of borrowing, which leaves you with more money to either pay down the loan sooner or to use for other purposes, such as fueling that latte addiction.  For example, if someone in the 40% tax bracket pays 5% interest on a $100,000 loan that is 100% deductible, his real cost of borrowing is really only 3%; although the bank still gets the 5% interest each year ($5,000), the taxpayer will also qualify for $2,000 in tax relief, which means he is really only out of pocket $3,000.   His tax refund is calculated as: $5,000 (the deductible expense which is subtracted from his income) x his marginal tax rate (40%) or $2,000.    As a result, he is $2,000 ahead of the guy next door who also borrows $100,000 at the same interest rate but who doesn’t get to write off the interest.  For those of you that are still ‘interested’, the easiest way of determining the real interest rate on deductible loans is by multiplying the stated interest rate by one minus your marginal tax rate.  Accordingly, if you are paying 4% interest on a completely deductible loan and have a marginal tax rate of 30%, your real cost of borrowing is 4 x (1 – .30), which is the same as paying non-deductible interest at 2.8%.

In some case, only part of the interest on a loan is deductible.  For example, if you have $50,000 on your line of credit, $20,000 for business expenses and $30,000 for remodeling your kitchen, you would only be able to deduct 40% of the interest, which is the deductible portion of the debt divided by the total debt ($20,000 / $50,000).  If this is the case, any payments against the balance of the loan are generally applied against the deductible and deductible portions in the same ratio already in place.  In other words, if you paid $5,000 against the principle of the loan we just discussed, $2,000 or 40% of the $5,000 would be applied against the deductible debt and the remaining $3,000 against the non-deductible 60%.  When the dust settles, the total loan would be down to $45,000, of which $18,000 (40%) would be deductible and $27,000 (60%) non-deductible.   As we will discuss later, it would have been far better to keep the two debts separate and pay interest-only on the deductible portion until the non-deductible loan has been paid in full.  Finally, for those of you who want to figure out the real cost of borrowing on partially deductible loans, multiply the stated interest rate times (1 minus (the marginal tax rate times % of the loan that is deductible.))  By way of example, assume the loan we just mentioned is 4% and borrower was in the 30% tax bracket.  In that case, the real interest on the blended loan is 4% interest x (1 –(.40  x .30)) or 4 x .88, which equals 3.52%.

Turning from why deductible debt is better than non-deductible debt, the next step is determining whether a loan qualifies for this tax relief.  Fortunately, our government buys into the idea that sometimes you need to borrow money to make money.   Generally, to get a write off, the interest must be:

•          the result of a legally enforceable loan taken out for the purpose of producing income from a property or business (i.e. interest, dividends or rent);

•          charged at a “reasonable” rate (i.e. not excessive, such as trying to paying artificially high interest to a low income relative in order to create a bigger deduction); and

•          paid that year (in other words, if you don’t pay interest on the loan that year, you can’t claim a deduction on it);

In addition, if the loan is for business purposes, there must be a reasonable expectation of profit on the business enterprise.  Generally, the CRA isn’t particularly pleased if they feel that you are really just trying to claim a deduction on one of your hobbies.  The CRA previously tried to impose some firm rules governing this situation, but the courts took a different view.  In the end, your accountant will be able to fill you in on more details if you are still in doubt on this front.  As well, there are there some other “if, ands and buts” that can apply in some other situations where you want to deduct interest that your accountant can explain, such as when you borrow to purchase annuities or other investments that pay less interest than what you are paying on your loan, which might limit the amount of interest you are able to deduct;

Expanding on the first condition, which requires that the loan be taken out to earn “income,” it is important to know that “capital gains” are different from “income.”    In the past, the CRA takes a generous view regarding investment loans; so long as there is a chance that the investment might pay dividends in the future,we have been able to write off all of the interest on the loan from inception even if you borrowed to buy stocks that pay a tiny dividend or no dividend.  Unfortunately, there is a recent case that is working its way through the courts that may result in the CRA taking a tougher stance in the future.  Although this case is likely to be appealed and deals with private company shares rather than publically traded securities, you may wish to ensure that the stocks you purchase through investment loans do pay a dividend until this is resolved.

On the other hand, the CRA isn’t nearly as permissive when we borrow to buy raw land in the hopes of flipping it to a developer later.  For those of us who aren’t land developers, the CRA won’t allow us to claim any of this interest on bare land unless we are renting out the land along the way.   On the other hand, if you are receiving rent from a farmer on your bare land you can deduct some of the interest (but only up to the amount received in rent after claiming any other deductions), although you can also add the unused interest to the purchase price of the property when figuring out the capital gains bill at the time of sale.   Although this isn’t as good as getting your deduction right away and even though this really means that you only get to write off half of this additional interest (since only 50% of the capital gain it is applied against is taxed anyway), it is a lot better than nothing.

Examples of Deductible Debt

Here are some situations where you may incur deductible debt:

  • borrowing to purchase investments  that do or might produce income(which is often referred to “leveraged investing”);
  • borrowing to buy a business or for business reasons (i.e. buying a new photocopier);
  • buying a rental property  that actually produces rent; and
  • renting out a suite in your home or using your home as the headquarters for your home-based business.  In this situation, you would be able to only deduct a portion of the mortgage owing on your house equal to either the square footage or number of rooms used for rental / business purposes divided by either the square footage or total number of room in the whole house.  For example, if you use 300 square feet or 1 room in your 1000 square foot 4 room condo for business purposes, you’d be able to write of 30% of the interest if you measured by square footage or 25% if you measured by calculating rooms.

Strategies for Targeting Debt or for Maximizing or Creating Deductible Debt.

Although we are almost out of time and space, I don’t want to leave you without a few useful tips to get started.  Although I plan on laying out more strategies and opportunities in future articles, here are a few bones to gnaw on in the meantime:

  • When you have a mix of fully deductible, partially deductible and non-deductible debts to pay down, start by figuring out the real interest rates on each of the loans as explained previously and compare.    In some cases, your deductible debt might still have the highest real interest rate even after calculating in the tax savings, such as if you take out a business loan at 6% and have lower non-deductible debt, such a .9% interest rate on the new family car.  In that case, even if the real rate on the business loan gets reduced to about 3%, you are still better off paying that down ahead of the non-deductible car loan.  Don’t assume that deductible debts should always be at the last ones paid!

Next, focus on paying down the loan with the highest real interest rate first and then target the next highest, and so on.  Even while targeting your higher interest loans, be sure to continue making minimum payments on your other loans, including interest on your deductible debt.  This protects your credit rating, avoids any penalties and ensures that you can continue to claim your interest deduction.

  • If married or in a common law relationship for tax purposes, do the above calculations for your combined debts, taking into account your different tax brackets when deciding which debts to pay down first.   Unless you like to keep your finances separate, with each spouse responsible for their own debts, calculate the real interest rates for both spouses on all loans and have spouses focus on paying that down, regardless of who owes  it (unless there are bankruptcy, legal or similar concerns.)  In some cases, a high income spouse might correctly identify her 3.99% mortgage as a higher priority despite have a 6% business loan but might miss out on the money saving opportunity of helping paying off her husband’s non-deductible 8% loan.   When comparing between spouses, all things being equal, deductible loans will be more valuable for the spouse in the higher tax bracket.
  • Keep deductible and non-deductible debt separate when possible.  This allows you to target payments towards the higher real rate loan rather than having part of your payments attributed towards the non-deductible debt when the two debts are combined.  This may be some exceptions to this rule; if the only way to consolidate a bunch of different higher rate loans, of which only some are deductible, is within a line of credit, then it still might make sense to go ahead.  All the same, do try to get separate loans or a bank products that allow you to have subaccounts within the same loan as described later in this article.

If you do have a blended account, there are some accountants who do try to track payments on a blended account separately but it is far easier and safer to keep them separate in the first place.  If you have a blended loan, consider taking out a new loan for future deductible expenses if you can get the same rate and are planning on taking on future deductible debt.  By making interest-only payments on the new loan and paying down the old one, you will increase the amount of debt you can deduct in the future.

  • Talk to your banker about all-in-one mortgages or lines of credit that allow you to keep and track a series of subaccounts within the same loan.  This allows you keep your debt separate and creates a wonderful paper trail if you are ever audited.  I will probably talk about all-in-one loans, such as the Manulife One, the Redfrog and National  Bank’s offering, to name a few, in a future article.
  • Although paying down the loans with the lowest real rates is usually the way to go, it might not always be the case.  For example, some mortgages may cap the size of any extra lump sum payments you make per year or by how much you can increase your regular payments.  While it makes sense to understand and take advantage of both, be careful of incurring penalties by exceeding these limits.  Likewise, if you have both variable and fixed loans and are worried about rising interest rates, you might want to want to hammer down the variable debt even if it is slightly lower than the fixed debt after factoring in interest deductibility.  Of course, you may also want to explore converting some of your variable debt to fixed debt as well.

On a similar note, if you have debts that are life insured, you might want to target other loans without this benefit, especially if you are in poor health or planning to scale Mount Everest next month.

  • Consider selling investments or business assets to pay down non-deductible debt and borrowing back to repurchase them.  For example, if you owe $300,000 against your non-deductible mortgage that is just coming due but also have a dividend-paying stock portfolio worth $300,000, consider selling your stocks, paying down the mortgage, then borrowing to repurchase your portfolio.  When your wheeling and dealing is done, you will still own $300,000 worth of investments and a $300,000 loan, but now you have a 100% deductible investment loan!

If you have significant capital gains that can’t neutralize through capital losses, this might not work for you.  If, on the other hand, your investments are losing money, you will need to either wait 31 days to repurchase the sold stocks or to purchase different ones in order to avoid the superficial loss rules that won’t allow you to use these losses up until the repurchased stocks are also sold.  As well, your spouse, a company or trust you control can’t purchase within this period as well.


When describing tax planning to clients, I like to compare it to playing chess for money; in order to get the best result, you need to know the rules of the game and move your pieces around just so.   So long as you stay within the rules, there is a lot you can do to reduce your taxes, pay off your debts sooner and find more money for the other things in life.

Although the rules regarding interest deductibility may be a little complicated at times, it is often worth it to either master them yourself or to find someone who can help you rearrange  your chessboard to achieve the desired result.  In some of my future articles, I will talk about some other strategies that allow you to use maximize or create deductible interest.  In the meantime, I will leave some time for all of us to focus on the rest of our lives.

No comments yet

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: