It often makes good sense for couples to own their major assets, such as the family house, investment accounts and investment properties in joint name. If one spouse passes away, the asset automatically passes to the other, without probate or disposition.
However, when life changes such that one spouse’s income greatly increases or decreases, joint ownership of taxable assets may no longer be the best option from a tax perspective. Due to rules set forth by the Canada Revenue Agency (CRA) it can be difficult to allocate investment income in a favorable way between spouses. This article will explore those rules, as well as spousal loans as a solution.
In an ideal world, people would be free to move income between themselves and a spouse. Unfortunately, income and capital gains earned on assets owned jointly or by one spouse can’t be allocated to the other. This is because the CRA has a set of rules, known as attribution rules, which prevent investors from transferring assets between family members with the intention of avoiding taxes.
The concept of attribution rules is straightforward: where did the money originate from? The individual whom the money originated from is responsible for the taxation. For example, if a husband and wife have an investment account held in joint name, any resulting income and/or capital gains must be split equally between them.
Attribution rules also apply to gifts between spouses. For example, if a husband gifts $10,000 to his wife and she invests the money, any income and/or capital gains earned on the investment would be taxed to the husband, not the wife. They could get around this, however, if the husband lent the money to his wife, rather than giving it. This concept is known as a spousal loan.
Transferring assets between spouses for tax purposes is only illegal when done without fair market value consideration. In order to achieve fair market value consideration, couples may consider a spousal loan.
A spousal loan is just what it sounds like. Spouse A lends money to Spouse B, who then uses the money to purchase assets. The assets can be those owned by Spouse A, or new ones such as real estate or stocks. Spouse B now owns the assets and is responsible for their taxation.
Spouse A must charge interest to Spouse B. The interest rate charged must be at least equal to the CRA’s prescribed rate, which is updated quarterly and can be found on their website. Effective April 1, 2018 the prescribed rate is 2 per cent. This rate may be locked-in until the loan is paid up.
How to do it
In order to use this strategy effectively, a few things must be in place. Firstly, a formal loan agreement must be completed, expressly stating repayment terms.
Secondly, Spouse A must charge interest to Spouse B as outlined above. There is no requirement to pay back the principal, only the interest. Spouse B must pay the interest to Spouse A every year. The money must actually change hands, so this is best done with a cheque. Missed payments will cause the attribution rules to kick in and Spouse A will be responsible for the asset’s taxation in the current year and in all future years.
Finally, Spouse A must include the loan interest on his or her tax return, and Spouse B will likely get to deduct the interest on theirs.
Spousal loans can be a very cost-effective way for couples to pay less tax overall but are only valid if done properly. Consult with your financial advisor and accountant to see if you might benefit from a spousal loan arrangement and be sure to work with an accountant to ensure things are set up properly.