Context: Paragraph (b)(i) of the definition of “disposition” in s. 248(1) says that the cancellation of a mortgage is a disposition of that mortgage.  Does it follow that every cancellation of a mortgage must give rise to a taxable event for the holder?  This simple question was at the heart of the decision in Leonard v. The King, 2022 FCA 195, as follows.

Federal Court of Appeal finds mortgage is not separate property:  In Leonard, a taxpayer had acquired a bank mortgage on a property owned by a insolvent person who was also indebted to the taxpayer (and many others).  The property was then put up for bid in a judicial sale process, as part of foreclosure proceedings.  The taxpayer ended up being the only bidder in the judicial sale (at an amount substantially lower than the mortgage debt), which resulted in the taxpayer acquiring the property and the mortgage being cancelled.  However, the remaining underlying debt obligation owed to the taxpayer was apparently not discharged in the foreclosure proceedings, because the taxpayer continued to hold a deficiency judgment against the insolvent person. 

  • Tax Court: At trial, citing paragraph (b)(i) of the definition of “disposition” in s. 248(1) noted above, the Tax Court judge concluded that there was a disposition of the mortgage when it was cancelled.  He then proceeded to determine that 99% of the taxpayer’s original cost of the mortgage and the underlying debt obligation of $1.3 million should be allocated to the mortgage “as a separate property” (see para. 49).  He then held that the disposition of the mortgage gave rise to a deducible loss for the taxpayer on income account.
  • Federal Court of Appeal (FCA): The FCA reversed the Tax Court’s decision (see para. 50).  Citing the Supreme Court of Canada’s decision in Royal Trust Co. v. New Brunswick (Secretary Treasurer), [1925] S.C.R. 94, the FCA confirmed that a mortgage cannot be separated from the underlying debt obligation that it secures (see paras 52).  Rather, a mortgage simply secures payment of that underlying debt obligation.  In most cases, this can operate to increase the value of the debt obligation by placing the holder in a higher priority than unsecured creditors, but that is all (see para. 57).  As a hedge, the FCA observed that even if the mortgage could be considered a separate property (it was not), no portion of the amount paid by the taxpayer to the bank for the debt obligation and the mortgage could reasonably be allocated to the mortgage (see para. 56).   

The takeaway: A mortgage is not a property separate from the underlying debt obligation that it secures.  Based on the decision in Leonard, where a mortgage is cancelled but the underlying debt obligation remains owing, no gain or loss should arise for the holder.