Do you pay taxes on borrowed money?

There may come a time in your life when you need to borrow money from a bank, credit union, or other lender---whether it be for a down payment on your first home, a new vehicle, emergency expenses, or other financial needs. That said, while loans serve as a financial stepping stone for Canadians, they can often raise questions about whether you need to pay taxes on the money borrowed.

To make sure you navigate this upcoming tax season, stick around to learn more about loans and applicable taxes.

The Income Tax Act of Canada

Before we get into how loans and taxes work in Canada, there are some things we need to go over, specifically the Income Tax Act, which governs how taxes work across the country. Essentially, this Tax Act is a large document that oversees and outlines the rules and regulations regarding income tax for everyday Canadians, corporations, various entities, and trusts. Here's a closer look at some key elements we think you should know about:

Income taxation

A portion of the Tax Act outlines different types of income within Canada. This includes business income, investment income, employment income, capital gains, benefits, retirement income, and more. Within this section of the act, you'll find the amount of income that is subjected to taxation, including credits, deductions, and allowed exemptions.

Taxation rates and tax brackets

Another important section of the Tax Act outlines tax brackets and rates that apply to individuals and corporations. Canada uses a progressive taxation system, which means the more taxable income you make, the higher your tax rate will be.

Beyond federal income tax, Canadians also need to pay provincial or territorial taxes each tax year. Again, each province and territory uses a progressive taxation system, which increases with each tax bracket.

Deductibles and credits

Deductions and credits are also outlined within the Canadian Tax Act. Deductions are incurred expenses taxpayers are able to deduct from their total income, which will reduce the total amount of taxable income for that year. Common deductions include home office costs, rent, utilities, transportation, and more.

In contrast, a tax credit is an amount you're able to subtract from your owed taxes instead of your income tax, reducing the amount of taxes you owe. Common tax credits include child and family benefits, tuition credits, medical expenses, and donations you may make to charities.

The Income Tax Act and entities

Canada has different types of entities, including individuals, partnerships, corporations, estates, and trusts. Within the Tax Act, there are different rules and regulations each entity must follow when filing and paying their taxes. Let's take a closer look at some key features you should know:

Anti-avoidance provisions

To prevent tax evasion, unethical avoidance schemes, and other acts, the anti-avoidance provisions enable the Canadian Revenue Agency (CRA) to investigate and challenge preparations and plans they deem suspicious.

Tax administration

The Tax Act also provides a framework for the administration and enforcement of taxation laws in Canada. The framework includes provisions regarding how Canadians report their income, how to file tax returns, how to make payments to the CRA for your taxes, and compliances that must be followed.

Capital gains taxes

The section dedicated to capital gains encompasses conditions that govern how capital gains are taxed. Capital gains are profits someone makes after they have sold an investment, property, or stock. Capital gains taxes are typically lower and often qualify for deferrals and exceptions.

Are loan proceeds considered taxable income?

There are numerous types of Canadian loans available, allowing you to borrow money based on your financial situation and unique loan needs. So, when it comes to borrowed funds, are the loan proceeds, aka the money you borrowed, subject to taxes? The short answer is no. You aren't obligated to pay taxes on the money you borrow. That said, there are some exceptions that you should be aware of. Here's what you need to know:

Personal loans

Generally speaking, when you borrow money through personal loans, you will not need to pay tax on the amount you borrowed. This is because the money you borrow is not considered income under the Tax Act, which means you are not obligated to report how much you borrow on your tax return.

Mortgage

Most Canadians require a mortgage loan on top of their down payment to purchase a home. Again, you won't need to pay taxes on your mortgage, given that the principal amount will be repaid to your lender. One thing to note, however, is that the interest paid on your home's mortgage could have tax implications.

Student loans

Again, borrowed money for student loans is not considered taxable income. If you're a student, you won't be required to pay tax on any grants you receive to finance your tuition as well. Further, if you received your student loan under the Canadian Student Financial Assistance Act, Canadian Student Loans Act, or another legislation within your province or territory, you may be eligible for a non-refundable tax credit.

Business loans

If you've borrowed money with the purpose of investing it into your business, then any interest paid on the loan proceeds can be used as a tax deduction. To ensure that you comply with CRA regulations, we recommend keeping records of all receipts from purchases you made on behalf of your business, as you may be asked to provide proof that the loan amount was used toward your business.

Auto loans

Looking for a new set of wheels? If you're thinking about borrowing cash to fund your new ride, you'll be pleased to know that car loans are also not taxable in Canada. That said, unlike student loans, you won't be able to claim interest paid as a tax deduction on your tax return. The only exception to this rule is if you use your vehicle for business purposes, then your interest payments could be listed as a business expense and deducted from your taxable income.

Credit cards

Money borrowed through credit cards is also not taxable, given that the money you borrow has no relation to the income you make throughout the year. As such, the interest you pay on the amount incurred will not be eligible for any tax deductions.

Do you pay taxes for interest paid on a loan?

While you won't need to pay applicable taxes on the interest you acquire on a loan, in some scenarios, you can claim a portion of your paid interest on your taxes. For example, you might be able to claim some of the interest on your primary or secondary property if it was used to generate income that tax year. Additionally, if you used a credit card to make business purchases, you could claim a portion of the interest as well.

Borrowing from your Registered retirement savings plan (RRSP)

Your registered retirement savings plan, or RRSP, is a type of investment account that Canadians use to save for their future retirement. Each year, you're able to invest 18% of your previous year's income into your RRSP. This money is then used to purchase various investments and is a great way to secure your financial future. The money you invest in your RRSP can then be used as a tax deduction on your taxable income for that year.

Regulations in the Tax Act prevent individuals from borrowing funds from their RRSP without any penalties. There are, however, exceptions to these rules, which we'll touch on a little later.

Taxes on your RRSP

Choosing to make early withdrawals from your RRSP will result in an immediate penalty, also known as a withholding tax. Basically, your financial institution will withhold a portion of the loan principal you withdraw as they are required to forward the funds directly to the CRA. How much withholding tax you're charged will depend on the amount you withdraw.

Beyond the withholding tax, the amount borrowed from your RRSP will be considered taxable income for that tax year at a marginal tax rate, which means there is a chance you could own further taxes beyond what you already owed through the withholding tax. Further, if you are unable to repay the borrowed funds according to the terms of your repayment schedule, you could also face penalties. When you over-contribute to your RRSP account, you'll need to pay a 1% penalty per the excess amount until it is fully deposited into your account by your contribution room in the future.

Exceptions for RRSP taxes

Generally speaking, you're only allowed to borrow money from your RRSP and avoid paying tax if the money borrowed is used for the Life Long Learning Plan or the Home Buyers' Plan, which are two programs in Canada that enable residents to fund their education or purchase a home:

Lifelong Learning Plan

If you're planning to go back to school full-time, but don't want to take out a personal loan, it makes sense to borrow money from your RRSP. Through the Lifelong Learning Plan, you're able to withdraw a total of $10,000 a year for you, your spouse, or your common-law partner, with a maximum withdrawal amount of $20,000 in four years.

Because you are using the money to fund education, you are not required to pay income tax on the amount borrowed if you pay back the borrowed funds within 10 years. Your first repayment into your RRSP will be due within five years, and any outstanding balance following this first payment will be included in your taxable income until you have repaid the entirety of the loan.

Home Buyers' Plan

With the Home Buyers' Plan, Canadians are able to withdraw a maximum of $35,000 from their RRSP when purchasing a home as a first-time homebuyer. The withdrawn amount will not be subject to tax. However, you must be able to repay the entirety of the loan proceeds into your RRSP within 15 years.

If, for some reason, you aren't able to repay the borrowed funds, the outstanding balance will be added to your taxable income each year of your non-repayment.

Tax deferrals on RRSPs

Should you decide to borrow funds from your RRSP account for the Home Buyers' Plan or Life Long Learning Plan, the money borrowed is technically a tax deferral, not an exemption. Here's what we mean:

You don't owe taxes immediately

Borrowing from this account does not subject you to taxes at the time you withdraw the funds, giving you a bit more freedom when it comes to this alternative type of "loan."

You must repay the money you borrow

As we mentioned, when you borrow money from your RRSP, you'll be responsible for paying the borrowed funds within a certain period--typically 10 or 15 years after your grace period has come to an end.

You owe taxes if you don't repay your debts on time

Lastly, if you are unable to repay the money you borrowed from your RRSP back in time, you'll pay taxes on the money you owe each tax year you are unable to pay.

No additional benefits

Because the money you borrow needs to be repaid into your RRSP, when depositing a second time, you won't receive a tax deduction like you did when you originally deposited the money.

What is debt consolidation?

Debt consolidation is the process of combining numerous minor debts or personal loans into one loan with one monthly payment. When you consolidate debt, you take out a larger loan and repay all of your lesser ones. By doing so, you'll only have to make one monthly payment, which can help you secure a better interest rate while making things more manageable.

Typically, if you have a poor credit score, consolidating your debt and conducting a credit repair are good options when trying to improve your overall score. When it comes to credit repair vs debt consolidation, both have their pros and cons. Depending on your financial needs and your overall plans for spending and saving, combining both methods can help you lower your loans while improving your overall credit score. However, we advise you to do more research before opting for either.

If you're unsure what your current credit score is, get a free credit score check and build your credit with KOHO!

Do you have to pay back borrowed money?

Yes, when it comes to borrowed money, borrowers are required to pay back the money they borrow plus interest to their borrower. That being said, if your borrower is a family member or friend, and you have not gone through traditional channels when borrowing money, you may not have to pay back the money with interest.

Taxes and business loans

Whether you're a new business owner or looking to expand your current business ventures, getting a business loan is a great way to buy stock, open a new location, and more. Similar to how personal loans work, business loans are not a tax deduction, which means you won't be required to pay any taxes once the funds hit your account:

Principal loan repayments

The principal amount of a business loan repayment is not deducted from income taxes. The principal amount reflects the loan repayment for the money that was borrowed. Therefore, the business loan is not taxable revenue, and instalments do not affect the company's tax liabilities.

Interest expenses

Any interest that you pay on your business loan can be written off as a business expense on your taxes, no matter what the loan amount was used for. Because of this, you'll be able to claim the interest paid as a tax-deductible from your business's overall taxable income for that given year.

Keep in mind that as a business owner, you'll need to keep a copy of your loan agreement and submit it to the CRA if you decide to claim the interest as a tax deduction. In the event that you are audited by the CRA, having a submitted copy of the loan agreement can help speed up the process.

Small businesses and taxes

With over 1 million small businesses operating in Canada, taking out loans is, again, a great way to fund certain aspects of your operations. However, as a small business, there are several ways small business loans can impact your company as a whole.

Similar to other business loans, with small business loans, you aren't allowed to deduct your repayment amounts from your taxes. However, the interest that you pay can be deducted. Ultimately, this can lower your overall taxable income and lower the amount you need to pay in taxes that tax year.

Costs you can deduct as a small business owner

As you're operating a business, there are likely numerous costs you'll pay throughout the year. Luckily, because these costs relate directly to your ability to operate, you're able to claim a portion of your bills on your income tax, which can help you lower the taxes you owe. Here are some common business costs you can claim as a tax-deductible:

• Operating costs: These types of costs include utilities, rental payments for your property, equipment costs, office supplies, shipping and postage, and any telephone or other communications bills you may have each month.

• Compensation for employees: Whether it be an employee life insurance policy, their salaries, wages, or other type of employee benefit you provide your workers.

• Business transportation: Should you need to travel for work, you can claim your travel costs, including your accommodations, food, rental car, gas, or flights.

• Business entertainment: Need to take out a client for dinner to close a business deal? Entertainment fees, including meals, meeting costs, networking events, and other types of bills in that tax year.

• Marketing and advertising: Whether it be digital marketing, print ads, or other types of promotional materials, any costs that enable you to reach your target audience that tax year can be claimed.

• Car insurance: If you have a business fleet or use your personal vehicle for business a portion of the time, you can claim a percentage of the expense on your taxes.

• Consulting or other professional services: If you obtain outside consulting or professional services that are business-related, they can be deducted from your income.

• Interest paid: This includes interest incurred on the money you borrow from loans, credit cards, and other lines of credit you've applied for.

• Training and education: If you're paying for education or training for yourself or your employees, these education costs can be claimed.

It's important to mention that there are costs for your business that you will not be able to deduct from your income taxes, including the following:

• Personal bills: Any vacations, accommodations, bills, clothing, or other costs that are personal and not business-related are not considered deductibles.

• Capital stock purchases: Any capital assets like land, equipment, or other investments made that year.

• Dividends: You can also not claim dividends you pay to your stakeholders that year.

• Fines: If your business is fined or penalized, you cannot claim these fines on your tax return.

• The interest you pay on a personal loan: Whether home loans, personal loans, or other lines of credit that are not related to your business.

Loans for shareholders

A shareholder loan is a type of loan that occurs when a shareholder borrows money from a corporation they own shares in or money they have loaned the corporation. When it comes to these types of loans, there are specific tax considerations you need to be aware of, including the following:

Corporation related loans

If you're a corporation operating in Canada and borrow funds from a shareholder, you can claim the interest you pay on the borrowed funds as a business expense. Keep in mind, however, that if the interest rate on the loan principal is high, the CRA could make an adjustment to the deduction.

Further, if the loan has not been paid by the end of the tax year, the borrowers may be subjected to rules in the Tax Act we mentioned earlier, where the shareholder's income is included in the loan.

Shareholder loans

On the other hand, if a shareholder decides to borrow money from your corporation, the loan amount will not be considered a loan for taxes. However, if it is a forgivable loan, where the funds are given without the need for repayment, the loan may be a tax benefit. Again, if the borrowed money has not been repaid within that tax year, the borrower may be taxed on the remaining balance, as stated within the Tax Act.

Paid salary and shareholder loans

Corporations often pay a salary to cancel out shareholder loans, often by providing the shareholders with compensation for their services. When this occurs, this "salary" can be regarded as a loan repayment or employment income. Let's take a closer look at this below:

Loan repayment

Shareholders may utilize the wage received to pay back the shareholder debt obtained from the company. By returning the loan amount to the corporation, the shareholder decreases or cancels the remaining debt owed to the firm. In terms of debt forgiveness, should the loan be repaid without interest, it can be considered a tax benefit.

Employment income

The salary paid to the shareholder can be considered their employment income on their taxes. However, this salary is subject to EI premiums, CCP contributions, and tax. As such, the corporation will deduct taxes and submit them to the CRA for the shareholder. At the end of the tax year, the corporation will provide the shareholder with a T4 slip.

Does borrowed money count as capital?

If you access cash as a borrower and use the borrowed funds to make an investment, it will be considered borrowed capital. Also known as loan capital, a company may borrow funds to grow its profits, which can be borrowed in the form of credit cards, personal loans, loans with collateral, and more. When it comes to interest, it is always the amount of money borrowed.

How is interest calculated on loan proceeds?

When it comes to loans, the borrower will need to pay interest on the money they borrow from the lender. So, how is interest calculated? Is interest calculated monthly or yearly?Essentially, a lender will calculate your interest rate in two different ways, using simple interest or amortization.

When a lender uses the simple interest method, the amount you pay in interest will remain the same over the course of your repayment schedule. In other words, your monthly payments for interest won't change, so you'll know exactly what you owe each month. When calculating interest using a simple interest method, you take the loan amount and multiply it by the interest rate and loan term in years to get the total amount of interest owed.

In contrast, with an amortization interest schedule, your payments toward the interest will decrease over time while the portion that goes toward the principal balance will increase.

How to get a loan in Canada

Borrowing money in Canada is fairly straightforward. Whether you need to pay off debts, purchase a property, pay for tuition, or cover emergency expenses, depending on what your financial plan and needs are, there is a loan out there for you. Here's how to get a loan and the steps you need to take:

1. Shop around and compare interest rates: Before signing your loan agreement, the best thing you can do is shop around and compare different lenders. Each lender will offer different interest rates and repayment terms. As such, if you're looking for a loan that reflects your financial needs, comparing costs upfront and how much you'll pay in interest can help you secure a loan agreement you feel comfortable in.

2. Fill out your loan application: Once you've settled on a lender you wish to borrow money from, you'll then need to fill out a loan application. During this time, the lender will run a credit check on you and take a look at your overall credit history. Depending on what your current score is, you may either be approved or denied.

3. Have your loan deposited: Now that you've been approved for your loan, the money will be deposited directly into your bank account. It is now yours to do whatever you want with it.

4. Pay your loan off: To ensure your credit remains intact, making your monthly payments on time is a must. You'll also need to pay back the money you borrow, plus interest, by the time your loan term has ended.

Are there risks when you borrow money?

The risk of personal loans for Canadians will vary between individuals and households. However, before borrowers approach lenders and apply for funding, it's essential to be aware of these risks. Here's what you should be aware of:

• Negatively impact your debt-to-income ratio: Taking out a bank loan may have a negative influence on your debt-to-income ratio. This ratio effectively analyzes how much of the money you make every month goes toward debt. Many lenders evaluate this ratio to assess the strength of your credit and if your financial situation will allow you to take on further debt.

• May worsen your financial situation: Taking on more unneeded debt than you can handle may result in your failure to make monthly payments, which will boost the overall remaining sum you have to pay to your lender.

• A higher rate for poor credit: The worse your credit score is, the greater the risk to financial institutions. If you do get authorized, expect shorter loan terms, higher interest rates, and a more rigorous approval process.

• Inflexible repayment terms: After you sign a personal loan contract and get your bank loan, you are locked in until the payback term is completed. In some cases, you may even suffer prepayment penalties if you attempt to pay off the remaining sum sooner than negotiated with your lender.

How to tell if getting a loan is right for you

Getting a loan isn't for everyone. So, how can you tell if taking on more debt is the right financial strategy for your current situation? Here are some things to keep in mind during the entire loan process:

• You have a good credit score: A good credit score is required to qualify for a lower interest rate. It may also let you increase your loan amount without having to put up collateral, which you would otherwise lose if you were unable to repay your principal. If you've got a good score and want to enhance your credit history, taking on another loan may be favourable.

• Your current debt obligations are low: If you don't have a lot of debt to begin with, considering a loan as a means of financing a large purchase may be advantageous if you're financially able to keep up with your loan commitments.

• You have a steady income: A steady source of income can also have a significant role in determining whether taking out personal loans is a wise financial move. Having a consistent job and regular paycheques can provide you peace of mind, knowing that you may avoid interest costs for late payments. Someone who works for themselves and receives an inconsistent salary might want to reconsider.

If you're still unsure whether taking out a loan is right for you, we recommend speaking with your financial advisor. They will be able to help you come to a conclusion based on your current financial health and financial goals for the future.

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