How to Deduct Mortgage Interest from Your Taxes?
Believe it or not, Canadians miss out on over $2 billion in unclaimed mortgage interest tax deductions every single year. Taxes can be a daunting topic, but failing to leverage the mortgage interest deduction is leaving serious money on the table for Canadian homeowners. As a mortgage broker, I've seen firsthand how much of a difference this one tax move can make to someone's bottom line.
Key Takeaways:
- Only certain types of mortgages are eligible for interest deductions in Canada
- Rental properties and investment properties allow you to deduct mortgage interest
- The Smith Maneuver is a strategy to make your principal residence mortgage tax-deductible
- You need to follow specific rules from the CRA to claim mortgage interest deductions properly
In this comprehensive guide, I'll walk through exactly how the mortgage interest tax deduction works in Canada, who qualifies, and most importantly, how you can maximize your savings. Strap in - by the end, you'll be an expert on this often misunderstood but hugely beneficial mortgage tax deduction in scenario.
Table of contents
The Two Requirements for Tax Deductible Mortgage Interest in Canada
In Canada, the Canadian Revenue Agency (CRA) only permits mortgage interest deductions in two specific situations (see Income Tax Act (R.S.C., 1985, c. 1 (5th Supp.)):
- The property generates rental income
- The mortgage utilizes the Smith Maneuver strategy
Let's dive into the details of each:
1. The Property Generates Rental Income
If you borrow money to purchase or carry out repairs/renovations on a rental property, the mortgage interest is considered a tax-deductible expense by the CRA. This is one of the biggest tax advantages of becoming a landlord.
A few key points on deducting rental property mortgage interest:
- Deduction is Based on Square Footage: If you only rent out part of the property, you can only deduct the portion of interest that corresponds to the rented area based on square footage.
- Also Deduct Other Fees: Other fees related to the mortgage like appraisal, insurance, legal, accounting and more are all deductible for rental properties as well.
- Rental Income Must be Reported: You must record and report your rental income accurately on Form T776. Your mortgage interest deduction will be calculated based on this income.
To maximize your mortgage interest deductions this tax season, it's ideal to rent out your entire property for the whole year if possible. But renting even a portion can provide great tax relief.
Here's an example of how it works for a property rented for part of tax time of the year:
| Rental Period | 6 months |
| Interest Paid | $12,000 |
| Rental Income | $18,000 |
| Net Income | $18,000 - $6,000 = $12,000 |
In this case, you could deduct $6,000 in mortgage interest (50% of taxable income of $12,000) since the property was rented for half the year. Your taxable net rental income would be $12,000.
2. The Smith Maneuver Strategy
The Smith Maneuver is a unique strategy that allows Canadian homeowners to make the mortgage interest on their principal residence tax deductible, despite the fact that under normal circumstances, it is not fully tax deductible anyway.
The basic idea is to take out a readvanceable mortgage, which combines a regular mortgage with a home equity line of credit (HELOC). Each month:
- You make your regular mortgage payment as usual
- You then re-borrow that amount back via the HELOC portion of your mortgage
- The re-borrowed HELOC funds get invested in income-earning investments
- The interest charged on the invested HELOC funds becomes tax deductible
Following this cyclical process essentially converts your mortgage from a personal debt to an investment loan over time. And in Canada, investment loan interest is fully deductible against any income source.
While the Smith Maneuver is legal and CRA-compliant, it is fairly complex to implement properly. I strongly advise speaking to a tax specialist before attempting this strategy.
Step-by-Step Guide: How to Deduct Mortgage Interest
Now that we've covered the two scenarios that allow for deducting mortgage interest, let's go through the actual process step-by-step:
1. Understand Your Eligibility
The very first step is determining if your mortgage interest payments are eligible for deductions based on the two criteria above:
- Rental property
- Investment property used in a business
- Principal residence using the Smith Maneuver
If your mortgage does not meet one of those three conditions, then unfortunately the interest is not deductible based on current laws.
For those with eligible mortgages, continue on to step 2.
2. Track Your Mortgage Interest Payments
You'll need to carefully track your total mortgage interest paid each year if you want to claim the deduction. Many mortgage lenders provide an annual statement breaking down the principal and interest portions of your mortgage payments.
If not, you can use this formula to calculate your deductible interest:
Mortgage Interest Paid = Annual Mortgage Payments x Periodic Interest Rate
For example, if you paid $24,000 in mortgage payments for the year and your periodic interest rate is 4%:
$24,000 x 4% = $960 in Deductible Mortgage Interest
3. Claim the Deduction on Your Tax Return
Once you know your total deductible mortgage interest amount for the year, there are three main ways to claim it:
| Deduction Method | Tax Form | Who Can Claim? |
|---|---|---|
| Rental Income | T776 | All rental property owners |
| Business Income | T2125 | Self-employed using property for business |
| Investment Expenses | Line 22100 | Those utilizing Smith Maneuver |
Simply enter your deductible mortgage interest amount on the appropriate form when filing your tax return.
4. Provide Supplementary Documentation
The CRA may request documentation to validate your mortgage interest deduction claims, so it's critical to keep supporting paperwork like:
- Mortgage statements showing interest paid
- Rental income statements or lease agreements
- Investment account statements (for Smith Maneuver)
- Receipts for any other deductible mortgage expenses
Maintain complete and accurate records in case you get audited.
5. Consider Working with a Professional
While the mortgage interest deduction seems simple on the surface, there are many nuances, particularly when it comes to rental properties and investment income situations.
To ensure you maximize your deductions while staying compliant, it's wise to enlist a qualified tax professional, at least initially. They can review your unique situation and optimize your mortgage interest deductions properly.
Bonus Considerations & Strategies
1. Accelerating Your Mortgage Payments Can Reduce Deductions
One common strategy to pay off a mortgage faster is to accelerate payments by paying more frequently (weekly or bi-weekly instead of monthly for example). However, this gives you less deductible interest compared to the standard payment schedule.
2. Refinancing Your Mortgage Can Impact Deductions
When you refinance, the deductibility of your new mortgage interest will depend on how you use that new money. If it's for further investment purposes, the interest may remain deductible. But a cash-out refinance for Personal reasons would make that portion non-deductible. Refinance your mortgage!
3. Smith Maneuver is Best for Long Mortgage Terms
The Smith Maneuver takes many years to fully convert your mortgage to tax-deductible status. It works better with longer mortgage terms to maximize the re-borrowing periods.
4. Understanding the Alternative Minimum Tax (AMT)
If you have a very large mortgage interest deduction, it could potentially trigger the AMT, which aims to limit excessive tax deductions for higher income earners. While uncommon, be aware of this potential limitation.
5. Deduct Other Related Housing Costs Too
In addition to mortgage interest, there are many other potential deductions for rental properties like property taxes, insurance, maintenance/repairs, professional fees and more. Maximize all related housing deductions.
FAQs
Is mortgage interest tax deductible in Canada?
In general, mortgage interest on your primary residence is not tax deductible in Canada according to the Canada Revenue Agency (CRA). However, there are certain scenarios where you can claim mortgage interest as a tax deduction:
- If the mortgage loan was used to purchase or renovate a rental property that generates rental income
- If you employ the Smith Maneuver strategy to convert your principal residence mortgage interest into deductible investment loan interest
What types of mortgage and interest expenses are tax deductible?
The interest portion of your mortgage payments can potentially be deducted if:
- It relates to a mortgage loan used to earn rental income from a rental property
- It relates to mortgage financing obtained for investment properties or to borrow for investing purposes (Smith Maneuver)
Mortgage interest costs on personal home loans for your primary residence do not qualify for deductions.
How do I deduct rental property mortgage interest generating rental income?
If you earn rental income from your property, you can deduct eligible expenses like mortgage interest on your tax return by reporting the income and expenses on Form T776. The deduction is based on only the portion of your property and time period it was rented out.
Is mortgage interest an operating expense or capital cost?
Mortgage interest is considered an operating expense rather than a capital cost. This means it can be deducted fully against your rental income each year, unlike capital expenses which must be depreciated.
Can I deduct mortgage interest if I work from home?
No, simply having a home office is not enough to make your mortgage interest tax deductible. Your mortgage interest is tax deductible if your home is being used to generate rental income or business income through active operations like running a storefront business.
How does the Smith Maneuver make mortgage interest tax deductible?
The Smith Maneuver is a debt restructuring strategy that converts your regular mortgage into a tax-deductible investment loan over time. It involves taking out a readvanceable mortgage and investing the re-borrowed funds, making the interest charges tax deductible against investment income and a capital gains tax too.
Does refinancing impact mortgage interest deductibility?
Yes, refinancing can potentially impact your ability to deduct mortgage interest depending on the purpose of the new mortgage loan. If you are refinancing for investment or business purposes only, the interest may remain deductible. But a cash-out refinance for personal expenses would make that portion of the interest non-deductible.
Final thoughts
Taking the time to understand and properly claim your available mortgage interest tax deductions can result in massive tax savings over the life of your mortgage - easily into the tens of thousands of dollars.
As an experienced mortgage broker, I cannot overstate the value of leveraging every possible deduction, credit and tax strategy available to you as a Canadian homeowner. With some upfront effort, you could be putting a lot more money back in your pocket each year.
If you have any other questions about maximizing your mortgage interest deductions or obtaining a tax-friendly mortgage product, please book a consultation with me today!
