Interest expense on borrowed money is deductible for income tax purposes, generally only if the borrowed money is used for the purpose of earning income from a property or business.
For example, if I take out a loan to buy mutual funds, the interest on the loan will normally be deductible. Furthermore, if I later sell the mutual funds and use the proceeds to buy another income-earning property, the interest will remain deductible. On the other hand, if I use the proceeds for personal or non-income earning purposes, such as to pay off my personal credit-card debt or take a vacation, the interest will be non-deductible from that point on.
One of the potential problems relating to these rules arises when you acquire property with a loan and then sell the property at a loss, and use the proceeds for non-income earning purposes or to partially repay the loan. For example, say I borrow $100,000 to buy some shares, later sell all of the shares for $40,000 and use the proceeds to partially repay the loan. Under a strict approach to the above rules, it would appear that $60,000 of the loan ($100,000 minus the $40,000 partial loan repayment) is no longer used for income-earning purposes. This is in fact how the courts interpreted the rules, which eventually led to a specific “disappearing source” rule in the Income Tax Act (section 20.1) that remedies this situation.
Under this provision, the amount of the original loan in excess of the proceeds of disposition of the property is deemed to be used for the purpose of earning income from property. Therefore, an interest deduction will remain for that portion.
Using the numbers above, the $100,000 amount of the original loan, minus the $40,000 proceeds for the property that is used to partly pay down the loan, is deemed to be used for the purpose of earning income. Therefore, interest on the $60,000 outstanding part of the loan will remain deductible.
What if the $40,000 was not used to repay part of the loan, but rather was used for personal purposes? In other words, under this scenario, the entire $100,000 of the loan would remain outstanding. Under the above provision, interest on $60,000 of the loan would remain deductible, while interest on the other $40,000 would not be deductible.
A similar rule applies if you borrow money for use in your business, you subsequently cease to carry on the business, and the value of the business properties is less than the amount of the outstanding loan. In general terms, in this scenario, a portion of the loan is allocated to any property that you dispose of on a fair market value basis (and for this purpose, there is a deemed disposition once you begin to use the property for any other purpose). The deduction of the interest on that portion of the loan depends on whether you use the proceeds of disposition for an income-earning purpose. The remaining part of the loan, if any, is deemed used for the purpose of earning income from a business, and the interest expense on that part remains deductible.