Friday, March 6, 2009

Lending Your Way to Tax Savings

The recent economic crisis has seen a marked decline in interest rates. This can give rise to income-splitting opportunities.

Say that I earn a significant income but my wife has no income. I can lend money to my wife so that she can invest and earn her own income. Unless my wife annually pays me a minimum amount of annual interest, however, I (not my wife) will have to pay the tax on any income or capital gains that she earns from the investments. This is one of the many “attribution rules” scattered throughout the Income Tax Act. Even though the investment income belongs to my wife, it is “attributed” to me for income tax purposes unless my wife pays me that minimum amount of annual interest.

That minimum amount of annual interest is based on the Canada Revenue Agency “prescribed rate of interest”. With the recent decline in general interest rates, that prescribed rate of interest has declined to just 2%.

Say that I lend $10,000 to my wife and she invests that money. My wife will have to pay me 2% interest ($200 per year). I will include that $200 in my income and my wife will deduct that $200 in computing her income. Any return in excess of 2% is taxed as my wife’s income, at her lower tax rate. Even a GIC would pay about 3% interest. Other investments – even in these dire economic times – can pay up to 7% and even more. If my wife (the borrowing spouse in this example) pays tax at a lower rate than me (because she earns less income), the difference in our tax rates means an annual tax savings.

With proper documentation, that 2% rate can be locked in indefinitely. Assuming that the economy will eventually recover despite the doom and gloom out there, a timely loan to a lower-income spouse can result in significant long-term tax savings.

In summary, the spouse with the higher income lends to the spouse with the lower income, who pays interest to the higher-income spouse at the 2% rate and gets to pocket – and pay tax on – any excess return.

Most economists predict that the current recession will be with us for some time. Interest rates in the United States are already near 0%, and it is possible that the Canada Revenue Agency prescribed rate could decline even further (from 2% to 1%) in an upcoming quarter. If this happens, the rate will be at an all-time historic low. Borrowing at 2% does not necessarily mean that you lose out if the rate declines to 1%. If the borrowing spouse is very sweet to the lending spouse, it might just be possible to convince the lending spouse to refinance the loan at that lower rate. I won’t speculate on the exact incentives that the borrowing spouse might have to offer for refinancing, but I have faith that it will be more romantic than the last time you refinanced a loan with a bank.

-- Blair P. Dwyer

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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.