Deducting Mortgage Interest on Rental Properties – A Complete Guide by a Montreal CPA Firm Near You

Introduction

For Canadian landlords, one of the most important tax deductions is mortgage interest on money borrowed to earn rental income. Yet many rental property owners either under-claim this deduction, claim it incorrectly, or misunderstand how refinancing and advanced strategies like the Smith Maneuver affect interest deductibility. CRA does not care what the loan is called—it cares what the borrowed money is actually used for. That means tracing the use of funds is critical. This guide explains how mortgage interest works for rental properties, how to structure borrowing properly, and how to avoid CRA problems.

Legal and Regulatory Framework

Interest deductibility is governed by section 20(1)(c) of the Income Tax Act, which allows a deduction for interest on borrowed money used for the purpose of earning income from a business or property. For landlords, this means interest on loans taken to buy or improve a rental property is generally deductible, while interest on loans used for personal purposes (cars, vacations, consumer spending) is not. CRA applies the “tracing rule”: you must be able to show that the borrowed money went into an income-producing investment (such as a rental property). On Form T776 (Statement of Real Estate Rentals), deductible mortgage interest is reported separately from principal repayments, which are never deductible.

Key Court Decisions

In Ludco Enterprises Ltd. v. Canada, the Supreme Court confirmed that interest is deductible if there is a reasonable expectation of income, even if capital growth is a long-term goal. In Singleton v. Canada, the Supreme Court allowed a taxpayer to deduct interest where borrowing was structured to purchase an income-producing investment, even though personal funds were used to buy a house—solidifying the tracing principle and inspiring the Smith Maneuver. In Bronfman Trust v. Canada, the court denied interest where borrowed funds were used for personal purposes, emphasizing that the use of money—not the security for the loan—determines deductibility. These cases form the legal backbone of interest deductibility strategy.

Why Mortgage Interest Matters for Landlords

Mortgage interest is often one of the largest expenses for rental property owners. Claiming it correctly can significantly reduce taxable rental income, especially in early years when interest is high relative to principal. At the same time, incorrectly structuring or tracing loans can lead to CRA denying interest deductions, reassessing prior years, and applying penalties and interest. Understanding the rules allows landlords to structure borrowing tax-efficiently and safely.

Basic Rule: Interest on Money Borrowed to Earn Rental Income Is Deductible

If you borrow money to:

• buy a rental property

• pay for renovations or capital improvements to a rental

• refinance to fund another income-producing investment
  then the interest on that portion of the debt is deductible against rental or investment income. The principal portion is never deductible, only the interest. If part of the borrowed money is used personally, only the income-producing portion is deductible.

The Importance of Tracing Loans

CRA focuses on: “What did you do with the money you borrowed?” Key principles:

• If a loan is used 100% to purchase a rental property, then 100% of the interest is typically deductible.

• If a loan is blended—part rental, part personal use—only the rental-related fraction of interest is deductible.

• Refinancing does not automatically change deductibility; it depends on how the new funds are used.
  Proper documentation (lawyer’s statements, bank records, purchase agreements, renovation invoices) is vital to trace borrowed funds to the rental property or other investments.

The Smith Maneuver: Concept and CRA View

The Smith Maneuver is a strategy where homeowners with a readvanceable mortgage pay down their non-deductible home mortgage and then re-borrow the available equity to invest in income-producing assets (e.g., rentals or securities), converting non-deductible interest into deductible interest. CRA generally accepts interest deductibility where:

• borrowed funds are clearly invested in income-producing assets

• tracing is clear and well documented

• the investment is held with a reasonable expectation of income
  However, Smith Maneuver implementations must be carefully structured to avoid mixing personal and investment uses in the same line of credit and to preserve clean tracing.

Common Scenarios for Rental Mortgage Interest

1. Buying a New Rental Property

You obtain a mortgage specifically to buy a rental. Interest is fully deductible; principal is not.

2. Refinancing a Rental to Access Equity

If you refinance and use new funds to renovate the rental or buy another income property, interest on the extra borrowed amount is deductible. If you use the equity to pay personal debts, that portion of interest is not deductible.

3. Borrowing Against Your Home to Invest in a Rental

If you take a HELOC on your principal residence and use all the funds to buy a rental property, interest on the HELOC is deductible—even though the loan is secured by your home, not the rental. The key is use of funds.

4. Mixed-Use Borrowing

If borrowed funds are used partly for rental and partly for personal purchases, you must apportion interest. CRA may deny the whole amount if records are unclear.

Pitfalls That Cause CRA to Deny Interest Deductions

• Poor or missing documentation on how loan proceeds were used

• Consolidating personal and rental debts into a single mixed-purpose loan without tracking proportions

• Borrowing against rental equity for personal spending while continuing to deduct all interest

• Claiming interest on loans used to buy land or property not actually rented or not expected to produce income

• Using complex Smith Maneuver setups without clear tracing or proper record-keeping
  Once CRA questions tracing and you cannot demonstrate use of funds, interest deductions are at risk.

Mackisen Strategy

At Mackisen CPA Montreal, we help landlords and investors design and document borrowing strategies that maximize interest deductibility while respecting CRA’s tracing rules. We analyze loan structures, separate personal and rental borrowing, prepare clear interest allocation schedules, advise on safe Smith Maneuver implementations, coordinate with mortgage advisors and lawyers, and defend interest deductions during CRA audits. Our approach ensures that every deductible dollar of interest is fully supported.

Real Client Experience

A Montreal landlord who refinanced to pay personal debts continued deducting all interest; CRA denied a large portion. We reconstructed the loan tracing and recovered interest deductions on the investment-related piece. A client implementing the Smith Maneuver had mixed personal and investment uses in a single HELOC; we redesigned their structure to isolate investment borrowing and protect deductibility. Another investor used home equity to purchase a rental but had poor documentation; we gathered legal, banking, and notary records to prove tracing and preserve the deduction.

Common Questions

Can I deduct interest on my home mortgage? Only if the borrowed funds are used to invest or earn income, not for personal living costs. Does it matter what property secures the loan? No—the use of funds matters, not the collateral. Can I deduct interest if the rental is vacant for part of the year? Yes, if it is genuinely available for rent. Is the Smith Maneuver legal? CRA accepts interest deductibility when structured correctly and properly documented.

Why Mackisen

With more than 35 years of combined CPA experience, Mackisen CPA Montreal helps Canadian landlords, homeowners, and investors optimize interest deductibility safely and strategically. Whether you have a simple rental mortgage or a sophisticated leverage strategy like the Smith Maneuver, we ensure full compliance with CRA rules and strong audit protection.