Key Takeaways
- The useful question isn't "is it legal?" It's "is the interest on this line of credit deductible, on these facts?"
- Section 20(1)(c) looks at the direct use of borrowed money. Bronfman Trust is the leading case on that test; Singleton is often cited where borrowing is reordered.
- CRA's published guidance explains how it reads the law. It isn't approval of any plan.
The Question Most People Ask Is the Wrong One
"Is cash damming legal?" sounds like a yes-or-no question.
The transactions themselves are ordinary. You draw on a line of credit, pay real rental bills and prepay your own mortgage.
The question that actually matters is a tax question: is the interest on the rental line of credit deductible, for you, on your facts? That depends on the wording of section 20(1)(c), how courts read "use", and your records.
This page takes each in turn. For the strategy itself, start with our rental cash damming guide.
The Mechanics, in One Paragraph
Rent is an additional prepayment on your home mortgage. Rental expenses are paid with funds borrowed from a separate line of credit, through a dedicated expense account. Personal-use debt on your home goes down; rental-use borrowing on the line goes up. Total debt stays roughly level. Full detail: how rental cash damming works.
Section 20(1)(c): The Rule Itself
Section 20(1)(c) of the Income Tax Act allows a deduction for interest on borrowed money used for the purpose of earning income from a business or property.
Broken into its parts, the interest has to be:
- Paid or payable in the year, depending on how you report
- Under a legal obligation to pay it
- On borrowed money used to earn income from a business or property, and not exempt income
- Reasonable in amount
Rental income is income from property. A mortgage used to buy a rental is the everyday example.
Rental cash damming applies the same rule to a different use: borrowing to pay the ongoing expenses of a rental, rather than to buy it. A line of credit used only to pay a rental's expenses may be considered to have been used to earn rental income. Whether each condition is met depends on your facts. You should always seek independent tax advice if you are thinking about implementing these strategies.
Section 20(3): When Borrowing Repays Borrowing
What it says: borrowed money used to repay money previously borrowed is treated as used for the purpose the earlier borrowing was used for.
Where it comes up: part of every rental mortgage payment is principal. When the rental line funds that payment, it repays borrowing that was used to buy the rental, which is the situation section 20(3) speaks to. Ask your tax advisor to look at it specifically.
Direct Use and Tracing
"Used for the purpose of" is about what the borrowed money was actually spent on. Not what secures the loan, and not what you hoped it would free up.
This is called tracing. Follow the borrowed dollar to what it bought.
Bronfman Trust (Supreme Court of Canada, 1987). The facts: a trust borrowed to make a capital distribution to a beneficiary instead of selling income-producing investments, and the interest was not deductible. How it is cited: as the leading case on the direct-use test. The principle: interest deductibility generally turns on the direct use of the borrowed money, not on indirect benefits such as keeping investments you would otherwise have sold.
CRA Income Tax Folio S3-F6-C1, Interest Deductibility. What it is: CRA's published guidance on how it reads section 20(1)(c). It says the Act requires tracing the use of borrowed funds to a specific eligible use (paragraph 1.29), discusses the direct-use test and Singleton (paragraph 1.30), and discusses keeping borrowed money segregated in separate accounts, with a worked example (paragraph 1.34). It is CRA's reading of the law, not approval of any person, plan or implementation.
A 2003 CRA advance income tax ruling (2002-0180523). What it was: an advance ruling CRA gave one self-employed taxpayer about a line of credit used only for business expenses. How it is cited: as an example of how CRA analysed a separate-account arrangement on one set of facts. The principle: an advance ruling binds CRA only for the taxpayer and facts in the request. This one involved business income, not rental income, and the law has changed since 2003.
The practical consequence is simple. If line of credit money touches a personal purchase, lands in the rental income account, or pays a vendor without passing through the expense account, the trail gets harder to follow. When the use can't be shown, CRA may deny the interest.
Reordered Borrowing: Singleton
Singleton (Supreme Court of Canada, 2001). The facts: a lawyer withdrew capital from his law firm to buy a house, then borrowed to replace the capital in the firm, and the interest was deductible. How it is cited: in discussions of reordering or refinancing borrowing. The principle: it is the direct use of the borrowed money that is examined, not the wider arrangement around it.
Income-Earning Purpose: Ludco
Ludco (Supreme Court of Canada, 2001). How it is cited: in discussions of borrowing to invest, including the Smith Manoeuvre. The principle: earning income does not have to be the main purpose of the borrowing, as long as there is a reasonable expectation of income. Income means gross income, not net profit.
For a rental, the income is rent. The question is whether the rental is genuinely run to earn it.
More Than the Money Trail
A clean money trail is necessary, but it is not the whole tax question. CRA can look at the transactions as a whole and the facts around them.
What a tax advisor will likely look at: whether real money moved, whether real rental bills were paid, whether the rental is run to earn income, whether any step is circular or reversed, and how property is owned between spouses. Those are facts. They are why every transaction is documented.
These summaries describe how the sources are commonly discussed. They are not legal or tax advice about your situation.
What CRA Looks at in Practice
Most reviews of interest deductions come down to three questions.
Can you trace the money? Statements showing the line funding the expense account, and the expense account paying vendors. No shortcuts, no personal spending, no payments straight from the line.
Were the expenses rental expenses? Property tax, insurance, repairs and the rental's mortgage interest are rental expenses. Personal costs are not. Capital improvements, like a new roof or an addition, are treated differently from current repairs. Stretching the definition is the fastest way to a reassessment.
Can you prove it? Receipts, invoices and, for e-transfers, written confirmation that the work was done. The burden of proof sits with you.
If the answer to any of these is no, CRA may deny some or all of the interest and reassess, with interest on the reassessed amount and possible penalties.
Commingling: Where Most Problems Start
Commingling means mixing money borrowed for different purposes in one account or one balance.
Common examples: the rental expense account pays a personal bill. The rental line buys something personal. A rental mortgage is refinanced to pay off personal debts without separating the pieces. A rental bill is paid straight from the line.
Any of these can blur the trail, and the damage may reach beyond the single transaction.
That is why we start with your existing debts. How was each one created? What was each borrowing used for? Has a refinance already mixed purposes? Those answers shape the structure before any new borrowing is added.
The Role of Your Accountant
Your accountant prepares your return and advises on what you claim. Rental income and expenses, including any interest claimed on rental-use borrowing, are reported on Form T776, Statement of Real Estate Rentals.
Many accountants have never seen a cash damming structure because most landlords never set one up. That is normal. We give your accountant the transaction map, the account structure and the monthly records so they can see exactly how the money moved. We also spend up to an hour with them at tax time.
Freedom10 does not prepare tax returns, give personalized tax advice or determine your tax treatment. We design the strategy together and help you set it up, implement it and track it. You run it. You should always seek independent tax advice if you are thinking about implementing these strategies.
The Bottom Line
Rental cash damming is designed around section 20(1)(c) and CRA's published guidance on tracing borrowed money.
Whether the interest may be deductible for you depends on direct use, the nature of the expenses and the records. Those turn on facts. Our job is to make the facts clear, documented and easy for your accountant to see.
Check whether you're a fit with our eligibility checklist, or see the monthly mechanics.
Learn the Rule That Makes Tracing Matter
The free masterclass walks through section 20(1)(c), direct use and the account structure on a real example.
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This article is for educational purposes only and is not tax, legal or financial advice. Freedom10 does not prepare tax returns or give personalized tax advice, and how the strategies described here apply to you depends on your facts. You should always seek independent tax advice if you are thinking about implementing these strategies. Freedom10 is a financial strategy and education company.