Inter-Spousal Loans: A Rare Income-Splitting Opportunity

With the recently proposed tax reforms, more doors continue to close on opportunities for income-splitting between spouses. However, there is still one key strategy—the inter-spousal loan—that can minimize tax where one person in the couple earns significantly more than the other.

It’s a good idea to discuss this planning opportunity with clients in this situation well before year-end, while CRA’s prescribed interest rate for inter-spousal loans is still at the very low level of 1 percent. Who knows how long this attractively low tax rate will remain in effect?

Under normal attribution rules, any money transferred from one spouse, typically the higher-income spouse, to another is deemed to be taxable in the hands of the transferor, at that person’s higher marginal tax rate.  Income splitting opportunities are therefore thwarted.

However, inter-spousal loans are an important exception to this rule, as long as they are set up and adhered to correctly. With such a loan, any investment income earned from the money transferred to the lower-income spouse will be taxed at that person’s lower tax rate. This can lead to significant savings on the couple’s total tax bill.

Tax and financial advisors can calculate the tax advantages; setting up inter-spousal loans now at the 1% prescribed rate locks in the rate for the life of the loan.   That’s important with the real possibility of more interest rate hikes hovering for 2018.

What else do your clients need to know about interspousal loans?

• The loan must be documented properly in writing, for example with a promissory note, including repayment terms.
• The lending spouse must charge the other spouse interest at least equal to CRA’s prescribed rate (currently 1 percent).
• The spouse receiving the loan must pay the interest owing to the lender every year (by January 30). Failure to meet this condition will result in the normal attribution rules kicking in, meaning that income earned from the loaned money will be taxed in the hands of the higher-income spouse in that year and all future years.
• The lending spouse is required to report the interest received as income on his or her income tax return. Conversely, the borrowing spouse can deduct the interest paid on his or her tax return, as long as the loan was used to purchase income-producing assets with the potential of earning passive income, within in a non-registered account.
• The spouse receiving the loan is required to pay back only the interest due; there is no requirement to repay the principal.

Planning to split family income is an important part of year end that planning. See a DFA-Tax Services Specialist for help.

Additional educational resources:  CE Summits (November 21 to 28) Online Certificate Course:  Advanced Family Tax Preparation, Tax Strategies for Investors, Elements of Real Wealth Management, DFA-Tax Services Specialist^TM Designation Program

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