Understanding Canadian Investment Deductions
If you’re an investor in Canada with a non-registered investment account, you likely incur expenses to manage the investments and account for the investment income you earn. It’s important to keep track of those expenses — many of them are tax deductible. Here are some tips to help you minimize the tax exposure on your investments.
Deducting investment-related expenses
Certain expenses you incur to earn investment income are tax deductible. These include:
Investment counsel and management fees (only the portion of these fees related to services for your non-registered — that is, non-Registered Retirement Savings Plan or non-Tax Free Savings Account — investments are deductible)
Safekeeping, custodial, and safety-deposit box fees
Tax return preparation fees, if you have income from a business or from your investments (sometimes called income from property). This includes interest, dividends, rents, and royalties.
Interest on money borrowed to earn investment income, such as interest, dividends, rents, or royalties — but not capital gains.
Brokerage commissions are not fully tax deductible as incurred because they form part of the tax cost on the purchase of an investment or reduce the proceeds on the sale. In other words, these commissions will reduce your ultimate capital gain, or increase your capital loss on sale, but are not deductible on an annual basis against other sources of income.
Detail eligible carrying costs and interest in Part IV of schedule 4 of your tax return, Summary, Carrying Charges and Interest Expenses. Then enter the total on line 221.
Be careful when claiming interest deductions (and other investment expenses when no reasonable expectation of cumulative profits exists) from the investment in question. Plainly stated, your deductions may be denied if you’re not expecting to earn enough interest and dividends from your investment over the expected holding period to cover your interest costs over that same period. What’s more, capital gains are not good enough on their own to allow deductibility of your expenses; you must have a reasonable expectation to earn income from property which includes interest, dividends, rents, and royalties.
If you live in Quebec, you have additional rules to worry about. Specifically, for Quebec tax purposes you can deduct interest (and other investment expenses) only to the extent you’ve reported investment income in the year. Investment income for these purposes includes taxable capital gains. Any interest that is not deductible can be carried forward to offset investment income you have in future years.
Determining when interest is deductible on your tax return
The government makes it very clear when interest on debts is deductible for tax purposes. And if you’re planning to take out a loan and deduct the interest, you’ll want to ensure you are onside with those rules.
For your interest to be deductible, the following four criteria must be met:
There must be an obligation to pay the interest costs.
The interest costs must be paid or payable during the year.
The interest costs must be reasonable.
The borrowed money must be used to earn business income or income from property.
When funds are borrowed from a bank or other lending institution, a legal obligation exists to pay the interest annually. And because the investor and the bank are not related to one another, it’s safe to say that the interest costs are reasonable. Therefore, provided the interest is paid during the year or the lender could legally enforce payment, it is clear that the first three criteria are met.
The fourth criteria states that the borrowed money must be used to earn business income or income from property. The term business income is simple. It means you earn income from operating your own business or investing in someone else’s business. It gets a bit trickier when you consider income from property, which includes interest, dividends, rentals, and royalties — but not capital gains. The tax law is clear — when funds are used to generate primarily capital gains, the interest is not deductible.
The most common types of items purchased with debt where you will be able to deduct your interest include bonds, mutual funds, public company shares, and rental properties. Interest on debts incurred to purchase personal assets like a house is not deductible, although you’re able to use the equity in your home to secure a loan that is used for investment purposes. In that case the direct use of the borrowed funds is investing; therefore, the interest is deductible.
If you borrow to invest in an RRSP or TFSA, your interest is not tax deductible. Consider using your tax refund to pay off at least part of your loan in order to keep your non-tax-deductible debt to a minimum.
Leveraged investing is not for everyone, because it’s considered risky. Ask yourself whether you have a long-term investment horizon, sufficient personal cash flow to make loan payments (particularly in years where the investment cannot generate the cash flow to support its loan), and a high risk tolerance.
Even if your interest cost exceeds your investment income, you’re still entitled to deduct the excess against other sources of income if you’re expecting income in the future.
Special deductions for exploration and development investments
Did you invest in an oil and gas or mining venture? The type of investment may have been called a limited partnership, a flow-through share investment, or simply a tax shelter. Whatever the term, if you did invest, you’re probably entitled to some special tax deductions. One of the attractive features promoted in the selling of oil, gas, and mining investments is the tax write-offs (slang for deductions) available.
If you’re contemplating an investment in an oil, gas, or mining venture, be sure you completely understand the risks associated with the investment. A general rule is that the greater the tax saving, the riskier the investment. Be sure that such an investment falls within your risk-tolerance comfort zone. Invest based on the quality of the investment — not the tax saving provided by the investment.
Why are these tax deductions made available? The government thinks it’s a good idea to encourage oil, gas, and metal exploration in Canada, so the Income Tax Act contains provisions to encourage these activities. The Act provides oil, gas, and mining companies with significant write-offs for Canadian exploration expenses, Canadian development expenses, and Canadian oil and gas property expenses. A mineral exploration tax credit is also available when you invest in certain companies that are looking to raise capital for mining exploration.
Because many exploration companies do not have sufficient money to go out and explore for oil, gas, and metals, the Act permits these companies to turn to you for the funds. You’re the one actually funding the exploration and development, so you get the attractive tax deductions. This is referred to as the expenses being renounced to you. Because exploration is the government’s main initiative, and the exploration phase has the greatest chance of failure, the write-offs are greatest when funds are expended on exploration.
The promoter of the oil, gas, or mining venture will provide you with all the information you need to claim the allowable deductions on your tax return. Depending on the structure of the investment, you’ll receive a T101, T102, or T5013 slip. Instructions are provided on the back of these forms to assist in calculating your deduction.
You don’t have to take the maximum deduction. Any amount not claimed will carry over to the following year for a potential deduction using the same percentage figures. Why would you not want to take a deduction? Perhaps you expect to be in a higher tax bracket next year, so the deduction will be worth more in tax savings if you wait.