Playing The Banker With a Spousal Loan To Income Split

Monopoly Short Game Rules: One person is assigned to be banker. They win.

Somehow, I always end up being the banker when we play Monopoly. In the case of our family, it is because my kids are just learning the game and when my wife does it, money usually disappears from the bank and she disappears to Mexico where the authorities cannot find her.

As reviewed in our last post, it can be advantageous to help your spouse build their own taxable investment portfolio as part of your plan for income splitting. To do that, they need some money to invest with. That can come from having them work for the business, or a spousal RRSP. Another way  to boost the investment earnings that generate income taxed at a spouse’s lower marginal rate is to give them an investment loan.

That’s right. You get to be the banker and unlike Monopoly, there may actually be extra money in it for you.

The Basics of Being the Banker

Lending money to a spouse needs to meet specific requirements to avoid triggering the dreaded attribution rules or getting caught up in some other pitfalls:

  • It must be at the prescribed rate from CRA.
  • You need a promissory note to legally document the loan.
  • The recipient must pay that interest from their own funds before Jan 30 of each year, starting the year following that in which the loan is made.
  • The lender must declare the interest paid to them as income.
  • The recipient spouse can deduct the interest paid against their income if they use the loan to invest in assets that generate income.

In considering this strategy, you need to adhere to the above, consider the taxes you pay to access the money to lend out, the expected investment returns and type of payment, and your lower income spouses’ tax rates. Let’s explore each aspect in a bit more depth.

Lending at the prescribed rate from CRA

The current prescribed rate can be found here. It has been incredibly low, at 1%, since about 2014. However, it is set quarterly based on the average of the 90 day government treasury rounded up to the next whole number. The treasury rate just went above 1% in the current quarter. So, effective April 1st, it is highly likely that we will see the prescribed rate rise to 2%. As it rises, the short-term tax efficiency of this approach could decrease slightly in some cases, making this a very timely post! The good news is that the prescribed rate at which you make the loan can be used for the entire life-time of the loan and your lower income spouse is only required to pay the interest. So, that low rate can go on indefinitely if you lock it in.

Getting a promissory note

This is actually pretty simple. There are a bunch of free templates like at lawdepot.ca or documatica. The main aspects are that it is a demand loan (you can ask to be repaid on demand), interest only payments are required, and that the current interest will be in effect for the duration of the loan. The promissory note does not need to be notarized. Keep it safe in case of audit.

Interest Payments

These need to made annually before January 30th of the following year. Personally, we prefer to set up automatic monthly payments via our online banking. Life is already full of too many payments to remember and it makes for smaller chunks of money at a time. Keep transaction records of the payments in case of audit. It is also best that your spouse have their own personal bank account that the loan goes into and the payments comes out of, rather than a joint account. That personal account can be easily linked to his/her personal investing account. You want very simple and clean accounting in case of audit.

Claiming Interest Payments by the Lending Spouse

The lending spouse needs to claim the interest paid to them as income and report it on their tax return. This is where the strategy loses some efficiency. For example, currently with the 1% prescribed rate and 54% highest marginal tax rate, it would be at most 0.54% of a drag on your returns. The tax drag on your household income is actually less than that because the lower income spouse can deduct that interest against some of their income.

Deducting Interest Payments by the Recipient Spouse

The main consideration here is that the investments must be expected to generate taxable income. This means a spousal loan to top up an RRSP would not have deductible interest. Same with a TFSA – you should be gifting money for a TFSA anyway since any income generated in a TFSA is not reportable and therefore exempt from the attribution rules. These loans are for investment in a non-registered taxable account.

Further, the investments need to generate annual income. For example, a stock or bond that pays dividends or interest would be acceptable. An investment property that generates rental income was also be ok. Capital gains do not count as income for interest deductability. So, an investment that only grows via capital gains, like a non-dividend paying stock, would be a problem.

Deducting interest expenses and the dividend tax credit can be mood altering.

These guys just did the math.

Another interesting nuance is that while you need to expect to generate income from the investments to deduct the interest expense of the loan, the amount of income does not need to exceed the expense, as outlined in a CRA interpretive bulletin that I found on taxtips.ca. This means that the investing spouse could actually get a tax deduction from the loan interest plus a non-refundable tax deduction from the eligible dividend credit lowering the amount of tax that they pay on their regular earned income. They do need to have some taxable income to benefit since it is a non-refundable tax credit.

For example, a spouse with $20K/yr income with a $100K spousal loan at 2% interest who makes 4% in dividends, would earn an extra $4K in dividend income plus reduce their tax bill by ~$500. That should induce a slight smile. Let’s say that the portfolio also made a 3% capital gain which you pay no tax on until you cash in down the road. That is an increase in spousal assets of $7K and they pay $500 less tax now than if they had made nothing, thus allowing them to grow they investment portfolio even more. If they re-invest the tax refund, then it is actually a negative effective tax drag on their portfolio. That should induce more pleasure and bigger smiles than even a laughter yoga session.

What about the drag of the loan interest on portfolio returns?

When you borrow money to invest, you need to subtract the costs of borrowing from your returns. Some may think that since you are borrowing from within your household instead of from a bank that it doesn’t matter. The lower income spouse must pay the interest from their own funds in this strategy. If they are sharing house expenses and cut some of those without touching the invested money, then you could ignore it. However, if you are having the high income spouse pay for all living expenses to preserve as much of the lower income spouse’s capital for investing (recommending for building your spouse’s treasure hoard for intermediate-term income splitting) then you do need to account for interest drag. A dollar that they are spending paying the interest is a dollar that they aren’t investing.

The good news is that the interest is tax deductible which attenuates the impact immediately. Also, if you allow the portfolio to grow over time, the interest payment never increases. This means that the drag of the interest payment on portfolio returns shrinks over time. It may start at 1%/yr, but could be half that in ten years with average annual portfolio returns of 8%.

What happens if someone dies or the relationship dies?

The taxable account is the property of the lower income spouse and the loan is treated like any other demand loan.

  • If the borrower meets an untimely end, then the loan needs to be repaid as part of the settlement of her estate. That could be done by transferring investments at fair market value as payment in kind. Once the loan is retired, then her estate would be distributed as per usual.
  • If lender dies, then if it is part of his will, then the loan can be forgiven. If not in the will, then it would need to be repaid and then distributed as part of his estate.
  • If there is a divorce, then the marital assets and liabilities would be split up normally. The lender spouse could have the loan repaid and the money from the repayment, as well as the the assets in the borrower’s taxable account would be divided up as per the local laws.

Factors to ponder when considering playing banker:

  • This technique is most useful if you will need a taxable non-registered investment account as part of your retirement planning. If all you need is what you save in your TFSAs, RRSPs, and CCPC (without running afoul of the new CCPC passive income rules), then it may not be needed.
  • It is also most useful if you have excess after-tax cash for some reason, such a high salary or an inheritance or other wind-fall. If you need to draw money out of a CCPC to fund a spousal loan, then there is an opportunity cost to losing the tax deferred growth of that money in the CCPC. That has generally negated the attractiveness of this strategy for most high income professionals, but that may change for some under the new tax regime.
  • If you and your spouse make very similar incomes, then a joint account with equal contributions would likely make the most sense for estate purposes (bypassing probate). Of course, income splitting in general wouldn’t matter to you anyway.
  • Spousal loans are not difficult to set-up, but require some basic paperwork and record keeping. This is best done with separate bank and investment accounts.
  • It uses leverage to increase the size of a lower income spouses’ income generating assets. The leverage comes from the higher income spouse, magnifying the income splitting effectiveness.
  • The prescribed rate is likely to rise in a couple of months which will worsen the effects of interest drag if you are being optimally efficient by investing all of the lower income spouse’s income with the higher income spouse paying all living expenses. However, the effect is still small with a long enough time frame for growth.
  • The account needs to have the potential for income generation (not just capital gains) for the loan interest to be a deductible expense. The income does not need to exceed the interest and is best when in the form of eligible dividends.
  • Part of the effectiveness in using eligible dividend generating investments is to apply credits against the lower earning spouse’s income. It is most effective when the lower income spouse has taxable income to deduct against (since a non-refundable credit) and portfolio growth is boosted if the tax savings are re-invested into the account.
  • The effect of decreased tax drag on a taxable account is impressive when compounded over years. If you are retiring before age 65, or want to have the option, and need a taxable account, then using this strategy early to be proactive yields better results.
  • If the lower income spouse will have a lower income in retirement, then drawing money from her taxable account can be very tax efficient and increase your after-tax retirement income.

Would a spousal loan be a good strategy to consider for your planning?

Hopefully, I have helped give you food for thought. You could use the Spousal Loan Calculator with your own numbers and provincial tax rates (built in) to get a rough sense of what it could look like for you. Of course, this strategy needs to be part of a cohesive plan. You may be trying to make that yourself or using expert financial and tax planning advice (suggested for most high income people). Either way, it is important to be educated to maximize your financial health and piece of mind.

We personally have not used this strategy yet. We did start building up my wife’s taxable account as soon as the current government got elected since we figured that they would be targeting CCPC investments and income splitting. Up until 2018 we were able to do that easily with dividends from the corp and her salary. I still have not rushed to use a spousal loan yet because my focus right now is on leaving as much passive investment money in my CCPC as possible to maximize the grandfathered portion when the new rules come out in the upcoming budget (expected late Feb or early March). [Update April, 2018: Why we decided against using a spousal loan]. What we did do a few years ago is leverage some of our home equity to build her taxable account.

This was an information dense post. The next two posts will be using some case studies to examine the spousal loan strategy in two couples using the Spousal Loan Calculator. Prepare to meet Dr. Strange.

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