At today’s low interest rates, a tax-minimization strategy that uses a spousal loan to shift income-producing assets into the hands of the lowest-earning spouse makes more sense than ever.
Currently, the prescribed loan rate set by the Canada Revenue Agency is only 1% — the lowest it can go. A low-cost loan from one spouse to another can allow income-producing assets to be purchased by the lower-income spouse within a married or equivalent-to-married couple, resulting in far fewer taxes for a family in situations in which the marginal rate of one spouse is much lower than the other spouse’s. Splitting income with a spouse can also reduce or eliminate the old-age security clawback for the higher-income earner down the road.
“The strategy is best suited for couples for whom there is a significant disparity in income levels, with one spouse a high-income earner and the other a low-income earner or even a stay-at-home spouse, earning little or nothing at all,” says Carol Bezaire, vice president of tax and estate planning with Toronto-based Mackenzie Financial Corp. “The idea is to level the playing field between spouses.The loan can be of any size, as long as the borrower has enough income to pay the interest. If necessary, that income could come from investments held by the lower-income spouse.”
The Income Tax Act does not allow a high-income spouse simply to transfer assets into the hands of the lower-income or non-working spouse, or to give that spouse the money to purchase the assets. If either situation occurs, the attribution rules kick in — rules designed to prevent income-splitting in order to lower taxes — which would result in the income being attributed back to the higher-income spouse.
It’s also important that the borrowing spouse has enough money of his or her own to pay the interest on the spousal loan. If the CRA discovers the source of the interest payment is connected to the lending spouse, the attribution rules will apply once again. If the lending spouse underwrites or guarantees anything, it’s the CRA considers that to be the same as paying themselves.
If the borrowing spouse is purchasing some of the higher-income spouse’s assets with the spousal loan, the borrower must wait 30 days to make the purchase if the selling spouse wants to claim the resulting capital loss or gain.
Alternatively, assets can be rolled over seamlessly from spouse to spouse — in such a case, the transfer is deemed to have occurred at the original cost, triggering no capital gain or loss for tax purposes until the assets are sold by the low-income spouse.
There are other reasons to use spousal loans at this time. With some share prices depressed following the recent stock market sell-off, future gains will accrue to the purchasing (lower-income) spouse, with beneficial tax consequences.
Extending the tax break even further, the borrowing spouse may deduct the cost of borrowing from his or her own investment income.
“This is a great way for couples to allocate assets,” says Bezaire. “And they should look it at now, while we have attractive interest rates.”
The loan can be for a lifetime or for as many years as your client wants. The only requirement is that interest be paid on an annual basis, by Jan. 30 of every year. No matter what happens to interest rates in the future, if a loan is made now at the current prescribed rate, the rate will remain at 1%. Although the lender must report the interest received on the loan as income, at a 1% lending rate, that interest income would be relatively low.
To avoid the transaction being disallowed by the CRA, says Mark Goodfield, chartered accountant with Toronto-based Cunningham LLP: “The borrower has an indefinite amount of time to repay the loan, but it’s important not to breach the rules on the interest payment.”
Historically, the prescribed rate has averaged 5%-6%. At those higher rates, it is more challenging to find investments that yield a profit after the interest on the spousal loan is paid. At 1%, the level it’s been for two years, income-splitting strategies are more effective. Goodfield says the loan should be $100,000 or higher to make the paperwork worthwhile.
The loan should be formally documented with a promissory note that includes the date, the amount lent and the rate of the loan.
You might be able to lend a hand in the record-keeping to ensure that your clients are doing it correctly and perhaps add extra credibility by acting as a witness to the signatures on the loan document.
“The paper trail is important,” says Be-zaire. “It doesn’t have to be an official legal document; but if you’re audited, you would need a written loan agreement.”
It’s crucial both not to miss the interest payment deadline and to make sure there is proper documentation, such as a cancelled cheque, to prove the interest was paid in a timely manner.
If the deadline for the interest is ever missed, that year’s income and all future years’ income on the investments purchased with the loan will be attributed back to the lending spouse.
The borrowed funds can be placed in a variety of investments, including stocks, bonds, guaranteed investment certificates, a private business or property. IE