What you need to know about deducting interest on your taxes for investment loans

The interest expense when you borrow money, either through your margin account, an investment loan or a line of credit, and use it for the purpose of earning investment income is generally tax deductible.

This tax deduction is important since it can dramatically reduce your true, effective after-tax cost of borrowing. For example, if you live in Nova Scotia, and you pay tax at the top combined federal/provincial marginal tax rate of 54 per cent, your tax cost of borrowing $100,000 for investment purposes, using a secured line of credit at bank prime rate (currently around 3.45 per cent), is only $1,587 annually, assuming the interest is fully tax deductible.

But if you invest the loan proceeds in mutual funds, your tax calculations may become a bit more complicated depending on the type of distributions you receive and whether those distributions are reinvested.

Mutual fund investors typically receive distributions monthly, quarterly or annually. These distributions can consist of the fund’s net income (Canadian dividends, foreign income or other income) or capital gains, but sometimes they are classified as a “return of capital” or ROC, which typically arises when a fund distributes more cash than its income and realized capital gains in a particular year.

Any ROC distribution is not immediately taxable, but it reduces the adjusted cost base (ACB) of the units held, thus generally increasing the amount of capital gain (or reducing the capital loss) that will be realized when the units are redeemed. The amount of any return of capital is shown in Box 42 of the T3 information slip.