Spousal loan tax break to shrink

(September 20, 2004) Clients looking to split their income with a spouse should act quickly and get their loan in place quickly, according to tax experts. That’s because the cost of such a loan is set to rise October 1.

Spousal investment loans are a method of income splitting between spouses (or equivalent) in different income tax brackets. The higher income earning spouse makes a loan to the lower income earner for the purpose of investing. The money is then invested, allowing the loan recipient to claim a tax deduction on the interest paid to the spouse.

The prescribed rate — the interest rate the Income Tax Act requires to be charged on a spousal loan — will rise to 3% from 2% on October 1. While the prescribed rate fluctuates on a quarterly basis with the yield on government bonds, the interest charged on a spousal loan is locked in at the time the loan is made.

The interest must be paid at least once a year, before January 30, and the higher income earner must pay tax on the interest income. Since the interest paid is taxed in the hands of the higher income spouse, it would be wise to lock in the loan at the lower interest rate.

The income splitting strategy can also be used by business owners to reduce the company’s tax exposure.

“For businesses, a tax-free loan can be made from companies to shareholders and employees if the interest is charged at the prescribed rate,” says David Christianson, R.F.P., CFP, TEP, with Wellington West in Winnipeg.

“Alternatively, an interest-free loan can be made, and the taxable benefit ascribed to that loan will be calculated at the low rate of 2%. This rate also applies to certain low cost housing and other loan arrangements.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com