One of the underlying conditions of borrowing of any kind is simple: There must be a strategy for paying back both the principal and the interest. People with multiple types of debt must also prioritize which should be paid first. And this becomes crucially important as you start year-end tax planning.
Pay the taxman first
One of the most expensive forms of debt is money owed to the tax department. Canada Revenue Agency (CRA) will charge the prescribed rate of interest, plus 4% more on the taxes owed. But they will also charge the same rate of interest on unpaid penalties such as penalties for late filing, gross negligence penalties, and tax evasion, all of which can multiply the cost of the original tax debt many, many times over.
CRA can also require employers to send portions of employee’s income by garnisheeing wages; the same is true of pensions. Not only can they shut down your income, but they can take away your assets. Therefore, tax debt requires immediate attention and should be paid first.
Tackle non-deductible debt next
Non-deductible debt should be tackled next. This includes expensive credit card debt and the debt attached to buying a personal residence. Interest costs here are not deductible. Neither is interest paid when money is borrowed to invest in a registered savings plan like an RRSP or TFSA.
Deductible debt, on the other hand, includes the interest you pay on money borrowed for non-registered investments, as long as taxpayers can trace the use of the money to these purposes. The onus is on you to establish that the borrowed funds are being used for the purposes of earning income from a business (claim on business statement) or from property (claim on Schedule 4) or from your rental (claim on your rental statement T776).
Investment loans
When money is borrowed to buy securities, the investment must have the potential to produce “income from property.” If the investment does not carry a stated interest or dividend rate, which might be the case with some common shares or mutual funds, the interest costs on an investment loan may not be deductible. CRA will generally allow interest costs on funds borrowed to buy common shares to be deductible if there is a possibility of receiving dividends, whether or not they are actually received, but each case may be assessed individually upon audit.
If the investment for which you borrowed no longer exists or has substantially diminished because it has lost significant value, you may continue to write off the interest on the loan as if the underlying asset still existed. The amount considered “not to be lost” must, however, be traceable to the loan you are paying off. If you dispose of the asset at a loss, you may continue to write off the interest costs so long as the proceeds were used to pay down the loan amount.
Have a repayment plan
It can pay handsome dividends to borrow for the right things: to get an education, to purchase income-producing financial assets, rental properties and homes in which tax-exempt gains accrue. However, a “Plan B” must be available if you no longer have the financial means to fund that debt.
In those cases, where would you go to repay the debt? Taking money out of a TFSA seems like a good plan: There are no tax consequences, and the money withdrawn can be recontributed to the TFSA without penalty, providing reinvestment guidelines are met.
Another alternative is repayment from other tax-paid capital that is earning a lower return than the interest costs – a term deposit, for example, or a Canada Savings Bond. Another option, use your tax refund or other social benefits that are not yet allocated to another purpose.
Least attractive options include any withdrawal that generates taxes: money taken out of an RRSP, for example, or a capital asset with a large accrued gain.
Courtesy Fundata Canada Inc. © 2015. Evelyn Jacks is president of Knowledge Bureau. This article originally appeared in the Knowledge Bureau Report. Reprinted with permission. All rights reserved.
