What is Accrued Interest in Canada?
A look at what accrued interest is, how it applies to different types of loans and investments, and tax implications.
Accrued interest in Canadian real estate refers to the interest that accumulates on a debt, such as a mortgage or loan, over a period without being paid immediately. This impacts both buyers and sellers during real estate transactions.
Accrued Interest in Mortgages
In mortgage agreements, accrued interest is a common feature. Interest begins to accumulate on the principal amount when a borrower takes out a mortgage. Though calculated daily, the interest is not paid until the end of a specified period, such as monthly or annually. Canadian tax regulations stipulate that accrued interest on mortgages may have tax implications. For instance, interest on money borrowed to purchase or improve a rental property can often be deducted as a rental expense, provided it meets criteria set by the Canada Revenue Agency (CRA).
Tax Implications
Accrued interest must be reported as income for tax purposes, even if it has not yet been paid. This rule applies to investments such as Guaranteed Investment Certificates (GICs), where interest accrues annually but is only paid out at maturity. The accrued interest is taxed at the individual’s marginal tax rate in the year it is earned. For real estate, if a property is used to generate rental income, the accrued interest on loans taken for purchasing or improving the property can be deducted from the rental income, effectively reducing the taxable income.
Accrued Interest in Real Estate Transactions
During the sale of a property, any accrued interest on the mortgage must be settled. This is typically resolved during the closing process: the seller pays any interest accrued up to the closing date, and the buyer assumes responsibility from that point forward. This arrangement ensures the lender receives the full amount of interest owed, irrespective of property ownership changes.
Accrued Interest on Bonds and Other Investments
Accrued interest is also relevant to bond investments. Bonds usually pay interest semi-annually. The accrued interest is calculated from the last payment date to the date of sale or purchase. When a bond is sold, the buyer compensates the seller for the accrued interest, which is then added to the bond’s price. This accrued interest is not reported as income on the T5 slip but can be deducted as an investment expense on the tax return.
Deductibility of Accrued Interest
The deductibility of accrued interest for tax purposes depends on the use of the borrowed funds. Interest on funds used for personal purposes, such as purchasing a primary residence, is generally not deductible. However, if the funds are used to generate income, such as purchasing a rental property or other income-producing assets, the interest may be deductible. This distinction is important for real estate investors as it can affect their tax obligations.
Impact of Accrued Interest on Property Valuation
When assessing property value, potential buyers and investors must consider any outstanding accrued interest on existing mortgages or loans. Accrued interest represents a financial obligation that must be fulfilled, potentially impacting the overall cost of acquiring the property.
Accrued Interest and Loan Refinancing
When property owners refinance a mortgage, the accrued interest on the original loan must be addressed. Refinancing may involve paying off the existing loan, including any accrued interest, and taking out a new loan under different terms. This can be advantageous if the new loan offers a lower interest rate or better repayment terms, though it requires careful consideration of the accrued interest and any associated fees.
Accrued Interest and Soft Costs
In real estate development, accrued interest is often classified as a “soft cost.” Soft costs are expenses not directly tied to the physical construction of a property but are necessary for its development. These can include interest on construction loans, legal fees, and administrative costs. Effectively managing accrued interest as a soft cost is essential for developers to maintain financial control over a project and ensure accurate expense accounting.
Buyers and sellers should be sure to consult a tax accountant or financial advisor before taking out a loan with accrued interest.