The idea of one spouse “lending” money to the other may seem a bit strange. After all, you did vow to be together for richer and poorer. So, why would you loan your spouse money? For some couples, it’s a terrific tax strategy.
A Form of Income Splitting
Other than pension splitting, there aren’t many ways to even out a couple’s income. If one spouse earns far more than the other, a few credits and deductions can be transferred at tax time but not much else can be done to reduce the higher earner’s tax bill. A spousal loan can help.
To understand why a spousal loan can be a good tax strategy, you must first know how the Canada Revenue Agency (CRA) usually treats exchanges of money between spouses.
In most cases, if you gift money to your spouse to invest, any income earned on that money is subject to Attribution rules. This means that in the year you make the gift, any income the investment generates is taxable to the giver. So, if you give your spouse $100,000 to invest and the investment earns $5,000 that year, the $5,000 is included in your income, not your spouse’s. If you loan your spouse $100,000 to invest and follow the guidelines for spousal loans, attribution rules will not apply.
Charging Interest
One of the key elements to a spousal loan is interest. You must charge your spouse interest on the loan that is at least as much as CRA’s prescribed rate. For the past few years, the prescribed rate has stayed at 1% so you must charge at least this rate. Your spouse must pay you this interest on time in order to stay within the rules of a spousal loan. The good news is that there’s no requirement to pay back the principal, just the interest.
The Tax Savings
With a spousal loan, as long as the requirements are met, any income earned by the investment is assigned to the borrowing spouse at tax time. This can lead to substantial savings. How? Let’s look at an example:
Jim earns $90,000/year. His wife Marie works part time and earns $15,000/year. If Jim invests $50,000 and earns 6% interest, that $3,000 is added to his income at tax time. Because he’s in a higher tax bracket than Marie, he could pay up to $780 in taxes on the earnings.
If Jim loans Marie the $50,000 by way of a spousal loan instead, the couple could end up with a lower tax bill overall. If Marie invests the funds and earns $3,000 in interest, the $3,000 is added to her income at tax time. Because Marie’s in a lower tax bracket, she’ll only pay about $450 in taxes on the earnings. In this case, Jim only has to declare the 1% interest Marie is required to pay him ($500). Don’t forget that Marie can declare the $500 as an investment expense.
What You Have to Do to Use This Strategy Effectively
1) Make sure the loan is properly documented, just like any other loan, and includes repayment terms.
2) Charge interest that’s at least equal to the Canada Revenue Agency’s prescribed rate (currently 1%). This rate may be locked in until the loan is paid.
3) Make sure the spouse who receives the loan pays the interest that is due on the loan every year or within 30 days of the end of the year. A missed payment will cause the Attribution Rules to kick in. This means that the income generated by the loaned money to be attributed back to the spouse who loaned the money that year and in all future years.
You can read the details about the Attribution Rules on the CRA’s Interspousal and Certain Other Transfers and Loans of Property web page.