Getting out of debt: start with non-deductible debt

The tax system treats debt differently depending on what you did with the money. Interest on money you borrowed to earn business or investment income can often be deducted, but interest on personal debt, such as credit cards, a car you drive for personal use or the mortgage on your own home, can’t. So when you’re deciding which balance to tackle first, it helps to know that the tax rules give you no help with personal debt.

Interest you can deduct

The CRA’s general rule is that interest is deductible only if the borrowed money is used to earn income from a business or property, you’re legally obliged to pay the interest, and the amount is reasonable. The main cases:

• Investments. You can deduct most interest on money you borrowed to try to earn investment income, such as interest and dividends (line 22100). If the only thing an investment can produce is a capital gain, the interest isn’t deductible.
• A business. If you’re self-employed, you can deduct interest on money borrowed for business purposes or to buy property for the business. There are limits for passenger vehicles and vacant land.
• Rental property. Interest on money borrowed to buy a rental property can qualify, because the property is used to earn income. The CRA’s folio on interest gives real estate used to earn rental income as an example of an income-earning property.

What counts is how you use the borrowed money now, not what you pledged as security. Borrowing against your home doesn’t make the interest deductible or non-deductible; the use of the money does. It’s up to you to trace each borrowed dollar to an income-earning use, so keep records.

Interest you can’t deduct

• Personal purposes. The CRA tells self-employed people plainly not to deduct interest on money borrowed for personal purposes or to pay overdue income taxes. The same principle applies to everyone: no income-earning use, no deduction.
• Registered plans. Interest on money borrowed to contribute to an RRSP, TFSA, FHSA, RESP or RDSP isn’t deductible.
• Investments with tax-exempt income. Interest on money used to buy property whose income would be exempt from tax, or to buy a life insurance policy, generally doesn’t qualify.

The one personal-debt exception: student loans

Interest you pay on a government student loan earns a federal tax credit (line 31900) and a provincial or territorial one. You can claim interest paid in the year or in any of the previous five years, and if you have no tax to pay, you can carry the amount forward to any of the next five years. Interest on private loans, such as a bank line of credit used for school, doesn’t qualify, and neither does interest on a government student loan that you’ve combined or renegotiated with another loan. See Tuition credits and carry-forwards for the other education credits.

Why the difference matters when you pay down debt

With deductible debt, part of each interest dollar comes back to you as a lower tax bill, at your marginal rate. Non-deductible debt gets no such relief, so every dollar of interest comes out of after-tax income. So, from a tax point of view, non-deductible debt costs you more for each dollar of interest. You can find your marginal rate with the income tax calculator.

Two tax details are worth knowing:

• Mixed-use credit lines. If you use one line of credit or loan for both investing and personal spending, the CRA’s view is that each repayment reduces both parts in proportion. You can’t direct a payment to the personal part only. The CRA notes that keeping borrowed money separate from other funds makes it easier to trace.
• Restructuring. The CRA accepts that you can rearrange your borrowing and assets so that borrowed money is used directly for an income-earning purpose. Its folio gives the example of someone who sells investments, pays down the loan on a personal-use condo, then borrows again to buy investments. The new loan’s interest can qualify because of its current use. These rules are technical; read the folio before relying on them.

Using an RRSP to pay off debt

Taking money out of an RRSP to clear a debt has a tax cost. Your financial institution withholds tax when you withdraw, at a rate that depends on the amount and where you live. The full withdrawal is then added to your income on your return, and the tax withheld may not cover what you owe at your tax rate, so you could have more to pay when you file.

In short

• Interest on personal debt isn’t deductible. The exception is the credit for interest on government student loans.
• Interest on money borrowed to earn business, rental or investment income is generally deductible, if you can trace the money to that use.
• Keeping investment borrowing separate from personal borrowing makes the interest easier to trace.
• An RRSP withdrawal used to pay debt is taxable income in the year you take it.