Income splitting is one the of the most practical ways for families to reduce their taxes. If done properly, income splitting can allow a higher earning spouse to shift income to the lower earning spouse, who will subsequently be taxed in a lower tax bracket. Spousal Loans are an effective way to take advantage of income splitting.
What You Need to Know
The CRA has implemented a set of rules, known as attribution rules that limit a taxpayer’s ability to split their income with their spouses. The attribution rules state that any income, or loss on transferred property will be attributed back to the transferring spouse for tax purposes. Any net capital gains or allowable loss resulting from the disposition will also be taxable in the transferring spouse’s hands. There are, however, strategies investors can utilize to be exempt from the attribution rules.
The rules say that a taxpayer may not gift property to a spouse; however, they may utilize a spousal loan and avoid the attribution rules, as long as the following conditions are met:
- There must be a written agreement between the spouses that outlines terms for the repayment of the loan.
- The borrowing spouse must pay the lending spouse annual interest on the loan. The rate of interest must be in line with the CRA’s prescribed rate of interest which is set quarterly. The rate is currently 1%.
- The interest must be paid and documented. If it is not paid in any year, all income on the loan will be taxed back to the lending spouse.
If the aforementioned rules are followed, any investment income earned on the loan will be taxed in the hands of the borrowing spouse.
Spouse A has a marginal tax rate of 53.35%, while Spouse B has a marginal tax rate of 29.65%. Spouse A has received a $250,000 bonus at work. They would like to invest the proceeds in a security they believe will earn them 5%, but does not want to have the investment income taxed at their high tax rate. The spouses could then create a spousal loan agreement. Spouse A could loan Spouse B the $200,000 to invest, while charging 1%. This is what the tax savings could look like:
Scenario 1: No Loan
Spouse A tax on the Proceeds: ((250,000 X 5%) X 53.53%) = $6699
Spouse B tax on the Proceeds: $0
Total Tax Owed: $6699
Scenario 2: Loan
Spouse A tax on the Proceeds: ((250,000 X 1%) X 53.35%) = $1333.75
Spouse B tax on the Proceeds: ((250,000 X (5%-1%)) X 29.65%)= $3669
Total Tax Owed: $5003
Total Tax Saved: $1696
As you can see, there is a significant tax saving available, even with the 1% interest owed. These savings will only grow over time as the portfolio grows. The interest rate will remain 1%, so regardless of how much your portfolio grows you will never have to deal with a rising interest rate.
The Bottom Line
Spousal loans can be an effective tool for investors if correctly implemented. In order for this strategy to work, it is essential that you consider the following:
- Ensure that the interest payments are well documented, in case the CRA requests proof.
- Make sure the payments are made on time. If they are not, the loan is not considered to be in force and this strategy will not work.
This strategy may not make sense for everyone. There are some capital gain/ loss considerations when creating and stopping the loan, but your advisor can help you evaluate if this is a tax saving strategy that could work for you.