High net worth taxpayers in the top income brackets can still cut the tax hit on high-yielding investment returns. Yes, it means becoming a lender, usually to a lower- or no-income spouse, but the tax savings can be considerable. Here鈥檚 how it works.
A low-interest loan to family members is a good way for high-bracket taxpayers to split income with lower-bracket spouses or even children. The strategy hinges on the fact that if you just give funds to lower-income family members to invest, the so-called attribution rules kick in, and the any dividends, interest, or capital gains earned by that capital is 鈥渁ttributed鈥� back to you, so that you will pay the tax, not your lower-income family member.
However, if you lend the money to a family member to invest instead of giving it outright, any income or gains from the invested funds will be taxed in the family member鈥檚 hands. The only condition 鈥� and it鈥檚 strictly enforced 鈥� is that the loan be made at the interest prescribed by the Canada Revenue Agency. The prescribed rate is currently an unbelievably low 1%.
This would make a lot of sense from an income-splitting perspective over the longer term. That鈥檚 because the prescribed interest rate on the loan is good for the duration of the loan. And that duration could be years 鈥� or decades. However, as I said, the CRA is strict about adhering to the conditions of the loan, so interest must be paid back to you by Jan. 30 of the year following the year in which the loan is made and each year thereafter. If an interest payment is missed, the loan is disqualified.
The lender declares the interest on the loan as income, while the borrower deducts the interest payments on their return.
For the loan to make sense from an income-splitting standpoint, the return on the investment purchased with the funds must exceed the prescribed interest rate plus the rate of inflation. That鈥檚 currently a total of about 3%. Add in taxes payable at the borrower鈥檚 lower rate, and a minimum target investment rate of return of 5% to 6% is not out of the question.
Keys to making family loans:
路聽聽聽聽 Family 鈥渓oans鈥� are fraught with peril, because of the family relationships and emotions involved.
路聽聽聽聽 Do not lend to family members unless you can be certain of repayment.
路聽聽聽聽 Loans can be made between spouses or parents and both minor and adult children.
路聽聽聽聽 Treat the loan as a bona fidebusiness arrangement 鈥� that is, for a specified amount, time, repayment schedule, and with the CRA鈥檚 prescribed interest rate at the time of the loan.
路聽聽聽聽 Document the loan and interest payments. This can be done as a promissory note.
路聽聽聽聽 Ensure total interest owing is paid by Jan. 30 of each year following the year in which the loan is made.
Courtesy 漏 2015. , is president of . This article is not intended as personalized advice.
