Interest deductibility is one of the more complicated areas of tax a real estate investor will encounter. I`ll try to illustrate by way of some examples.
Lets say you have a $100,000 line of credit (LOC) that currently has a zero balance. You use $100,000 of the LOC to purchase a rental property (Property A). The interest you pay on the LOC would be deductible from the rental income you earn on Property A. At a later date you are able to pay off the entire LOC so the balance on your LOC is zero again. Now let`s look at a bunch of possible scenarios. These scenarios are independent of each other.
1) You borrow $100,000 from your LOC to purchase another rental property (Property B). The interest on your LOC could now be deducted from rental income earned on Property B.
2) You borrow $100,000 from your LOC to take an around-the-world vacation. The interest on the LOC would not be deductible.
3) You borrow $100,000 from your LOC to buy a cottage on the lake that you are not going to be renting out. The interest on the LOC would not be deductible.
4) You borrow $100,000 from your LOC to take a $50,000 around-the-world vacation and put a $50,000 down payment on a rental property (Property C). You would think that you could deduct half the interest on the LOC from the rental income earned on Property C but CRA could deny the deduction because the deductibility of the interest on the LOC has been "tainted" by the purchase of the vacation that you cannot deduct interest for.
5) Property A currently has no mortgage so you decide to get an $80,000 mortgage on Property A to purchase another rental property (Property D). The interest on Property A`s mortgage could be deducted from rental income earned on Property D.
6) Property A currently has no mortgage so you decide to get an $80,000 mortgage on Property A to take an around-the-world vacation. The interest on Property A`s mortgage would not be deductible.
And one more scenario... you have a rental property (Property E) that you purchased for $100,000 with an $80,000 mortgage, the interest on the $80,000 mortgage would be deductible from rental income earned from Property E. Time has passed and Property E is now worth $200,000 and has a mortgage of $60,000. You decide you want to take some of your profit off the table to enjoy life a bit so you refinance the property back to 80% and get a new $160,000 mortgage. You use the extra money to take a well earned vacation, buy a new car and to pay for your child`s University tuition. Is the interest on the $160,000 mortgage deductible? You have to look at what the funds from the $160,000 mortgage were used for, the funds were used for a vacation, a car, University tuition, and to purchase Property E. You are now in a situation similar to scenario 4) above. You can definitely not deduct the interest on the entire refinanced mortgage and CRA could possibly deny you the interest deduction on the entire mortgage because the mortgage has now been tainted due to part of the mortgage being used to purchase things that you cannot deduct the interest on.
These are just some possible scenarios, there are many, many more possible situations. The key is that you must be able to directly trace the borrowed funds to what the borrowed funds are being used for to be able to determine if the interest will be deductible. Don`t co-mingle your borrowed money and keep really, really, really good records of what the borrowed money was used for, do that and you have a much better chance of your interest deduction being allowed by CRA. No deduction is ever 100% guaranteed to make it through an audit by CRA but following the rules and keeping good records definitely increases the odds.