Can You Deduct Mortgage Interest on Your Taxes in Canada?

Introduction

In Canada, the rules regarding mortgage interest deductibility are different from those in the United States. Unlike the U.S., where mortgage interest on a primary residence is tax-deductible, Canadian tax laws do not allow homeowners to deduct mortgage interest on personal homes. However, there are several exceptions where mortgage interest can be deducted, including for rental properties, business use of a home, and debt-recycling strategies like the Smith Manoeuvre.

This article explores when and how Canadians can deduct mortgage interest on their taxes, covering rental income deductions, business-use deductions, and legal tax planning strategies.

1. When is Mortgage Interest Deductible in Canada?

Mortgage interest is not deductible on a primary residence unless it meets specific criteria. However, it can be deducted if the borrowed funds are used for income-generating purposes.

A. Mortgage Interest on Rental Properties

• If a homeowner rents out a property and earns rental income, the interest on the mortgage is tax-deductible.
• The mortgage must be directly linked to the purchase, improvement, or refinancing of the rental property.
• The deduction applies to:
  • Interest on the original mortgage used to acquire the rental property.
  • Interest on refinanced loans, provided the new funds are used for rental property purposes.
  • Home equity loans (HELOCs) if the funds are used exclusively for rental income generation.

B. Business Use of a Home (Self-Employed Individuals & Home-Based Businesses)

• If a portion of a home is used exclusively for business purposes, a percentage of the mortgage interest is deductible.
• To qualify:
  • The home office must be the primary place of business, or
  • It must be used regularly to meet clients, patients, or customers.
• The deductible portion is based on the square footage used for business activities.
• Other related expenses (utilities, property taxes, maintenance) can also be deducted proportionally.

C. The Smith Manoeuvre (Debt Recycling Strategy)

• A legal debt-recycling strategy that converts a non-deductible mortgage into a tax-deductible investment loan.
• This works by borrowing against home equity and using the funds for income-generating investments such as:
  • Dividend-paying stocks
  • Investment properties
  • Interest-bearing securities
• Mortgage interest on these borrowed funds becomes tax-deductible, reducing overall tax liability.

2. How to Claim Mortgage Interest Deductions on Rental Income

If mortgage interest is linked to rental income, it can be deducted as an expense on the rental property tax return (T776 - Statement of Real Estate Rentals).

A. Steps to Deduct Mortgage Interest on a Rental Property

1. Determine the Interest Amount
   
   • Only the interest portion of the mortgage is deductible (not principal payments).
   • Obtain a mortgage interest statement from the lender.
2. Calculate the Deductible Percentage (If Partially Rented Out)
   
   • If renting out only part of a home, deduct only the proportionate amount of mortgage interest.
   • Example: If 30% of the home is rented, then 30% of mortgage interest is deductible.
3. Report the Deduction on Form T776
   
   • Enter the mortgage interest under Line 8710 (Interest and Bank Charges) of Form T776 when filing taxes.

3. Business Use of Home: How Much Mortgage Interest is Deductible?

• The amount of mortgage interest deductible is based on the percentage of the home used for business purposes.
• Example Calculation:
  • A home office occupies 15% of the total square footage of a house.
  • 15% of annual mortgage interest is deductible as a business expense.
• This deduction is claimed on:
  • T2125 (Statement of Business or Professional Activities) for self-employed individuals.

4. The Smith Manoeuvre: Making Mortgage Interest Tax-Deductible

The Smith Manoeuvre is a tax-efficient wealth-building strategy used by Canadian homeowners

A. How Does It Work?

1. Homeowners take a mortgage with a re-advanceable Home Equity Line of Credit (HELOC).
2. Each mortgage payment reduces the principal, increasing the available HELOC credit.
3. The homeowner borrows from the HELOC to invest in income-producing assets.
4. Since the borrowed money is used for investments, the interest on the HELOC becomes tax-deductible.

B. Key Benefits of the Smith Manoeuvre

• Converts non-deductible mortgage debt into deductible investment debt.
• Reduces taxable income by deducting HELOC interest.
• Increases investment capital, potentially generating higher returns over time.

C. Risks and Considerations

• Only works if the investments generate taxable income (e.g., dividends, interest, or rental income).
• Market volatility could result in investment losses.
• Strict record-keeping is required to ensure CRA compliance.

5. Mortgage Interest Deduction Restrictions and Common Mistakes

Even if mortgage interest is eligible for deduction, certain restrictions apply:

A. Mortgage Interest on a Primary Residence is NOT Deductible

• Exception: If part of the home is used for business or rental income.

B. Interest on Personal Loans is NOT Deductible

• If borrowed funds are used for personal expenses (vacations, cars, renovations not for rental purposes), the interest cannot be deducted.

C. Mixed-Use Loans Must be Carefully Tracked

• If a mortgage or HELOC is used partially for investments and partially for personal expenses, only the investment-related interest is deductible.
• Example:
  • A HELOC of $100,000 is used:
    • $50,000 for rental property down payment (deductible).
    • $50,000 for personal renovations (not deductible).
  • Only 50% of the interest is deductible.

6. Alternative Ways to Make Mortgage Interest Deductible

If homeowners cannot claim mortgage interest deductions directly, they can use alternative strategies:

A. Renting Out a Portion of a Home (Basement Suites, Airbnb, Room Rentals)

• If part of a home is rented out, a portion of mortgage interest becomes deductible.
• Rental income must be reported on tax returns.

B. Borrowing to Invest in an Income-Producing Asset

• Instead of paying down a mortgage with cash, using borrowed money for investments makes the interest deductible.

7. CRA Audit Considerations: Ensuring Compliance

To avoid issues with the Canada Revenue Agency (CRA):

• Keep records of all loan transactions to prove the funds were used for deductible purposes.
• Separate investment loans from personal loans to avoid complications.
• Consult a tax professional before implementing advanced tax planning strategies.

Conclusion

While mortgage interest on a primary residence is not tax-deductible in Canada, there are legal strategies to claim deductions, including rental property mortgage interest, home business use, and the Smith Manoeuvre.

By properly structuring mortgages and leveraging income-generating investments, Canadians can legally reduce their tax burden. 

Tax Partners can assist homeowners in implementing tax-efficient mortgage strategies while ensuring full compliance with CRA regulations.

This article is written for educational purposes.

Should you have any inquiries, please do not hesitate to contact us at (905) 836-8755, via email at [email protected], or by visiting our website at www.taxpartners.ca.

Tax Partners has been operational since 1981 and is recognized as one of the leading tax and accounting firms in North America. Contact us today for a FREE initial consultation appointment.