Spousal loan pitfalls

Much has been written about the opportunity for family tax savings that can be achieved by shifting investments from a high taxpayer spouse (“spouse” also refers to a common-law partner) to a lower taxpayer spouse. One of the more popular strategies is the use of a spousal loan.

This process requires the borrowing spouse to sign a promissory note for the amount borrowed and pay the lending spouse interest. The loan is a “demand” loan, meaning payable upon demand . The rate for the loan that is most often used for this is the “prescribed rate”, which is set by Canada Revenue Agency each quarter. This rate is at an historic low of 1% – making this strategy a great planning opportunity for advisors and their clients.

We have been speaking to financial advisors about this opportunity for some time now as the rates have been at 1% since April 2009. While the strategy makes great sense from a financial planning point of view, advisors and their clients have concerns about the implications of this strategy if one of the parties in the agreement passes away or if the clients suffer a breakdown in their relationship. Therefore, we’ll address these scenarios below so that you’re equipped if you decide to set up spousal loans for your clients this quarter.

Death of A Spouse

One of the primary concerns clients may have with respect to a spousal loan are the implications if one of the spouses in the agreement passes away. There are no special tax rules that apply to a spousal loan in existence at the time of death of the borrower spouse. This means that the loan is treated like any other outstanding loan in the estate, and would generally be classified as a “testamentary debt”. The personal representative (executor/estate trustee/liquidator) must review the will to determine if the deceased specified how the debts are to be paid. Unless the will instructs otherwise, the debts are generally paid out of the residue of the estate, which is the portion that is not specifically directed to a beneficiary (“specific bequests”).

Lender Spouse as sole beneficiary

John and Mary set up a spousal loan for $100,000 at 1%. Mary purchased $100,000 of John’s investment portfolio, and was paying John 1% interest each year. (Note: there are tax implications relating to the transfer of investments which have appreciated in value that are not detailed in this article). In the second year of the loan, Mary died. Although John, as sole beneficiary, received all of Mary’s assets, he needs to be careful about how the loan is paid off by the estate. He cannot simply take all assets in as an inheritance. Mary’s loan must be treated like any other outstanding loan, meaning an in-kind transfer of assets from the estate should be made to John to retire the loan before the remaining assets of the estate are distributed.

Lender Spouse and child as beneficiary

The spousal loan is a larger planning issue if the estate beneficiaries include individuals other than the lender spouse. For example: the same spousal loan between John and Mary was in place at the time of Mary’s death. Assume that John and his son, Michael, are 50/50 beneficiaries of the residue of Mary’s estate. In this case, the $100,000 loan to John must be repaid before the residue is calculated and distributed. This will provide John $100,000 more in estate value. Michael’s share of the estate will be calculated after the debts and expenses, including the repayment of the spousal loan.

If Mary’s estate assets are not enough to pay off the loan, John may consider forgiving it; however there are tax consequences to John in doing so. There are “debt forgiveness” rules in the Income Tax Act under Section 80(13) under which Mary’s estate has the ability to take the forgiven amount and apply it to reduce unused carryforward amounts for her terminal year, namely:

• non-capital loss carryforward
• farm loss carryforward
• restricted farm loss carryforward
• allowable business investment losses
• net capital loss carryforward

There are a few more atypical outstanding tax accounts that may be reduced but the above are the most common. Mary’s personal representative can offset any remaining unused forgiven amount by current year capital losses. If there is still an unused forgiven amount remaining then the personal representative will have to include that amount in Mary’s final return as income, taxable at a 50% inclusion rate. (This is covered in subsection 80(13) of the Income Tax Act). All of these rules may not be effective if Mary’s estate is intended to transfer on a rollover basis to John.

John, as the lender, may be able to make an election under subsection 50(1) of the Act to deem the unpaid balance of the loan to be disposed for proceeds equal to zero, and to have reacquired the loan at zero. This will create a capital loss for John as a bad debt, which he can use to offset any capital gains in the current year, previous three years, or carry forward to any future year. The ability to claim this election generally depends on the financial position of the debtor (in this case, Mary), and her estate’s ability to repay the loan. As you can see, for most spousal situations, this may not be the best course of action – paying off the loan may be the simplest and most direct method of settling Mary’s estate.

Lender Spouse Dies

Let’s change the facts of the case study and examine what happens if John (the lender) dies while the loan is still in place. In this case, the spousal loan can either be forgiven in the will of the deceased, or again, the debt owing may be paid to the estate. Depending on the instructions in John’s will, the personal representative will have to work with Mary to retire the loan. This is more easily accomplished if Mary is the sole beneficiary – settlement may have to be made if there are other beneficiaries whose inheritance will be reduced or eliminated if the spousal loan debt is larger than the residue of the estate.

Relationship Breakdown

The other issue to consider is how a spousal loan would be impacted if John and Mary separate or divorce while the loan is in place. Generally speaking, assets and debts accumulated during marriage would be divided between spouses upon marital breakdown (rules vary from province to province, so legal advice is very important). In our case study, John would generally be entitled to call the loan (as it is a “demand” loan). The spousal loan agreement is documentation to support that the note is John’s asset. If the loan is not repaid, then through the legal process of dividing the spouses’ property between them, the note and the associated investments will be considered. From a financial sense, the promissory note should not have any material impact on the division of assets during separation or divorce but rather, what may be left to divide amongst the parties is any appreciation on the investments made with the loan. As always in cases like these, it is important to speak to a family lawyer to determine the specific implications on your client.

Summary

The spousal loan strategy is useful in tax savings for many families. Death and marriage breakdown may sometimes complicate the client’s affairs, but the tax savings from devising such a plan cannot be ignored. Forward planning to co-ordinate wills and review estate plans will ensure the loan does not impair other estate considerations.

Carol Bezaire

Tax & Estate

Carol Bezaire , PFPC, TEP, CLU, is the vice-president of tax and estate planning at Mackenzie Investments. Carol can be contacted at: cbezaire@mackenzieinvestments.com