RRSP can house a mortgage

You've made your 2011 RRSP contribution a full two weeks ahead of the Feb. 29 deadline. Congratulations! But what did you invest in? GICs? Stocks? Bonds?

While most Canadians sock their funds away in those traditional asset classes, there are other potential uses for your RRSP money, and one of them could include your mortgage.

You can use the funds in your RRSP to invest in a mortgage on Canadian real estate. However, there are strict rules in place if you, or someone related to you, owns the property being mortgaged (i.e. your own home). Such a mortgage, known as a "non-arm's length mortgage," must be administered by an approved lender under the National Housing Act. The interest rate and other terms and conditions must reflect normal commercial practices. Finally, there must be private or CMHC mortgage insurance.

Of course, the advantage of investing in a mortgage through your RRSP should be weighed against the costs involved.

In addition to the typical onetime mortgage expenses, most financial institutions charge a mortgage administration fee each year. But by far the biggest upfront cost is the mortgage-insurance premium, which can typically range from 0.5% to 2.9% of the amount of the mortgage.

A recent Canada Revenue Agency technical interpretation, however, highlights a planning opportunity that could make holding a mortgage in your RRSP more palatable.

Consider Donald, who owns a second property, which he rents out to students. He is writing off the interest expense he pays to his financial institution for the money he borrowed to help fund the purchase of the property. We will refer to this as the "original loan." Donald decides to repay this original loan by taking out a non-arm's length mortgage funded by money from his RRSP, which we will call the "second loan."

The CRA was asked whether Donald would be able to deduct the interest paid to his RRSP as an expense on his tax return. Under the Tax Act, you can deduct interest paid on borrowed money for the purpose of earning income from a business or property. In Donald's case, he is properly deducting interest on the original loan because he used the proceeds from that loan to purchase the rental property from which he is generating income.

The Act says that if you borrow money to repay money that was previously borrowed, the new borrowed money is considered to be used for the same purpose for which the original borrowed money was used.

Since the interest on Donald's original loan was tax-deductible because it was used for the purpose of earning rental income, the interest on the second loan, paid to Donald's RRSP, will be tax-deductible as long as he continues to own the rental property for the purpose of earning income.

Jamie Golombek is the managing director, tax & estate planning at CIBC Private Wealth Management in Toronto.