Homeowner

# Calculating Hypothetical Interest on Early Loan Repayments

If you have a loan on an asset you use to earn income, you may be able to write off hypothetical interest when you incur certain fees. In particular, you may be able to write off hypothetical interest against your investment or business income if you pay an early loan repayment penalty or incur a fee to lower your interest rate.

## Rate Reduction Fees and Prepayment Penalties as Interest

If you have a loan or other debt obligation, you may incur a fee if you opt to reduce its rate or repay it early. If you pay this type of penalty or fee in the course of earning income, you can usually claim it as a business expense or deduction.

The Canada Revenue Agency considers these payments as interest payments on a debt obligation. Accordingly, you should deduct them on your income tax return. However, there are certain cases where these penalties are not considered interest.

## Penalties and Fees Not Deemed as Interest

Fees paid to extend the loan or to convert it to another type of debt obligation are not considered interest payments by the CRA. Additionally, your payments are not considered interest payments if they are dependent on production from the property, related to the property’s revenues, or computed based on shareholder dividends of a corporation’s capital stock.

## Reporting Deemed Interest

If your repayment penalty or interest adjustment fee is deemed interest by the CRA, you can deduct it in tax years after the year you paid the penalty. However, note that you can only deduct the amount of the payment related to the value of interest that would have been paid if the loan was not repaid early or if the interest rate was unchanged.

This amount is referred to as hypothetical interest. It needs to be measured at the time the payment was made, using either the straight line or present value method.

## Calculating Hypothetical Interest

The straight line method takes the remaining value of the loan prior to repayment and multiples it by the loan’s interest rate. Then, it multiplies this amount by the number of years left on the loan.

The present value method can use a range of formulas, but typically involves adding the interest rate to one and raising the sum to the power of the number of years left on the loan. Then, the formula divides one by this product and subtracts the resulting quotient from one. Finally, it multiples the difference by the loan balance.

## Reporting Hypothetical Interest

Reporting your deemed interest on your income tax return varies based on the type of return you file. For example, if you file Form T2125 as a self-employed individual, you would report interest as a business expense in section 5. However, if you are a landlord who files Form T776, you would report interest as an expense on line 8710.