Let’s start with this basic premise
Interest paid on a loan is deductible for income tax purposes, generally only if the borrowed money is used to earn property or business income.
For example, if I borrow money to buy mutual fund units, the interest on the loan will be deductible. What’s more, if I sell the units later and use the proceeds to acquire another income-producing asset, the interest will remain deductible. On the other hand, if I use the proceeds for personal purposes or non-income-producing activities, such as paying down a personal credit card balance or taking a vacation, then the interest will cease to be deductible.
Here’s where it gets complicated: selling a property at a loss when it was purchased with borrowed money.
One of the problems associated with these rules arises when you acquire an asset with a loan, then sell it at a loss, and use the proceeds for purposes other than generating income or partially repaying the loan. Suppose I borrow $100,000 to buy a few shares, sell them all later for $40,000 and use the proceeds to repay a fraction of the loan. Under a strict application of these rules, it would appear that $60,000 of the loan ($100,000 less the $40,000 partial loan repayment) is no longer used for income-producing activities. It is, in fact, the way the courts have interpreted the rules, which subsequently led to the adoption of a specific rule relating to the deduction of interest on the “loss of a source of income” in the Income Tax Act (ITA) (section 20.1) that remedies the situation.
Under this provision, the excess of the original loan amount over the proceeds of disposition of the property is considered to be used to earn income from the property. Interest will continue to be deducted on this portion.
And what happens when you stop running your business?
A similar rule applies if you borrow money for your business, you later cease to operate the business, and the value of the business assets is less than the amount of the loan balance. Generally, in this scenario, a portion of the loan is allocated to any property you dispose of at fair market value (and, for this purpose, there is a deemed disposition as soon as you begin to use the property for another purpose). Deducting interest on this portion of the loan depends on whether you use the proceeds of disposition for an income-producing purpose. The other portion of the loan, if any, is deemed to be used for the purpose of earning income from a business, and the interest on that portion remains deductible.
Would an example help you understand?
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Example
Using the above figures, the $100,000 original loan, less the $40,000 proceeds from the sale of the property, which is used to repay a portion of the loan, is deemed to be used for the purpose of earning income. As a result, interest on the $60,000 outstanding balance of the loan will remain deductible.
What would happen if the $40,000 wasn’t used to repay a portion of the loan, but rather for personal use? In other words, the entire $100,000 loan would remain outstanding. Under the above provision, interest on the $60,000 loan would remain deductible, while interest on the remaining $40,000 would not be deductible.
