We have previously discussed trying to build up a lower income spouse’s personal investment account as a strategy for intermediate-term income splitting. Intermediate-term income splitting may be useful if you require savings beyond what can be accommodated by your RRSPs, TFSAs, and Corporate accounts -necessitating a “cash” or “taxable” investment account as part of your plan.
In making your overall investment plan tax efficient, you’d want to have tax favoured investments (like capital gains and some eligible dividend generators) in that taxable account. Further, if you have a spouse with a much lower income, you want that income taxed in their hands.
As illustrated previously in The Sim Lab, building that account in a lower income spouse’s hands can result in a larger account over the years due to less tax drag on the compound growth. Plus, it can be more tax efficient to access the money via a lower-taxed spouse – particularly if you retire early. We examined that in the context of using spousal loans in the cases of a high income physician and a high income employee.
In this post, we are going to examine a different way of leveraging the investment income growth of a lower income spouse using an external source of money. Specifically, a bank loan with your family home as collateral. This can have the benefit of not only growing a lower income spouse’s income generation by releasing some of the money trapped in the equity of your home and putting it to work for you, but it also makes that portion of your mortgage/HELOC tax deductible.
There are a number of factors to weigh when considering using a home equity loan to help grow a lower income spouse’s investment income:
- Is a larger taxable investment account helpful to your overall wealth building plan, as discussed in the above intro to this post? If not, why bother.
- If so, then are you willing to accept the risks of using leverage to increase it?
- If you are willing, then how do you go about it to avoid triggering the attribution rules and having the money taxed in the higher income spouse’s hands?
- Invest so that you can deduct the loan interest as an expense.
The Risk/Benefit Analysis of Using Leverage
Leverage is borrowing money to invest with the hope of increasing your returns. It is a two edged sword. If you borrow money that generates more income than the cost of the interest, then you now have extra money that you wouldn’t have had otherwise. Conversely, if you invest and lose money or make less than the interest, then you end up paying more than you generate and still have the debt to deal with. Leverage magnifies losses or gains. So, it is important to consider the chances that you will end up ahead against the risks.
Factors to consider in your risk/benefit analysis of using an investment loan:
- Other debts that you may have. If you have a high interest loan, then it is usually better to pay that off first. It is like a guaranteed return of whatever the interest rate is – plus it is tax free.
- The interest rate of your mortgage or home equity loan. You need to be able to get returns beyond this to make a profit. For example, in the current ultra-low interest rate environment, you can get a five year fixed rate mortgage for around 3%/yr. That is pretty easy to beat with investments and is predictable. If you use a variable interest rate loan, then you can get a slightly better interest rate now. However, be aware that it will likely rise over the next few years.
- Your expected rate of return. If using a taxable account, you are likely going to invest in equities or equity based ETFs to earn tax efficient capital gains and eligible dividends. An average historical return on the TSX from 1970 to 2015 was ~10%/yr. However, past performance does not predict the future. Further, that is an average return over time. It can fluctuate wildly on a year to year basis.
- Can you stomach the volatility in your investments when you own them with borrowed money? Most of us investing have a long term view and acknowledge that our portfolio will fluctuate in value. With a balanced portfolio comprising of fixed income and equities, that volatility is smoothed out overall when you account for both components. However, the equity part of that portfolio is still volatile. Fear is one of the most powerful drives hardwired into our DNA. Right up there with food, sleep, and reproductive urges – all necessary for continuation of the species. If you give into fear and sell when your taxable account is down and you are leveraged, then you make that paper loss into a real one – and still owe the money! You need to be honest with yourself about your intestinal fortitude.
- Can you pay the money back if you need to? This is an important consideration. What if you lost all of the money invested – could you still pay it back over time? Of course, it would suck losing the money, but if you can survive losing it, then it is a mental game changer. You don’t want to feel like you need to sell your investments when they are dropping to pay back the loan. That feeling is like blood in the water to the fear sharks swimming around your primitive brain. The other practical reason is that you could be forced to pay back the money. If it is via a mortgage, you could qualify for less mortgage when you renew due to higher rates at that time or new qualifying rules. If the loan is a home equity line of credit, then it is a demand loan, which means the bank can ask for it to be repaid at any time, for any reason. You don’t want to be put in a position where you are forced to liquidate assets at a bad time to pay back the loan.
Avoiding Triggering The Attribution Rules While Using A Loan
When helping a lower income mate build their hoard so that you both can keep those pesky hobbit burglars from nibbling away at your treasure, you need to ensure that you don’t run afoul of the dreaded attribution rules. If you are not careful, the attribution rules are the weapon that the CRA will use to slay your plans and tax the investment income in the higher income spouse’s hands.
The attribution rules would apply to any income from a loan obtained solely on the credit of the higher income spouse (as an individual). However, a mortgage or home equity line of credit is a bit more complex because it is secured against the family home (as an asset).
There was a CRA interpretive bulletin issued on July 20, 2009 addressing this issue. Old bulletins are no longer on the CRA website, but there is a good summary here. I have not been able to find anything more recent. However, I did consult with my accountant prior to using this strategy in 2016 and he said that it was still totally legit at the time. Notwithstanding, I suggest that you consult with your CPA before using this technique to ensure that you follow all the rules.
- When a home is purchased by a couple with joint ownership, if one spouse does not contribute any capital to the purchase, then a transfer of value of that property is considered to be made to that spouse at that time at fair market value. That doesn’t trigger any taxes because buying or selling your principal residence does not result in a taxable capital gain or loss.
- A home equity loan (or mortgage which is essentially the same thing for this purpose – a loan with the house as collateral) is secured against the joint property, but is not a loan from one spouse to the other.
- It is the usage and servicing of the loan that determines attribution. If the loan is used by a lower income spouse and invested in their name, and that lower income spouse pays the interest on that loan, then the investment income should be attributed to that lower income spouse.
- Interest expenses for the investments can only be deducted against the lower income spouse’s income.
- You need to have a clear and clean paper trail. Keep records of the loan amount and all payments made by the lower income spouse. This is best done with the lower income spouse having their own personal account into which their paycheque goes and from which they pay the loan. Make all deposits to and from the spouse’s investment account via that bank account. Not your joint account.
- CRA also raises the specter of applying the general anti-avoidance rule. That is the CRA bazooka that they can use to kill any maneuver that is used to avoid paying tax.
Invest so that the loan interest can be deducted as an expense.
For an investment loan to be deductible against income (which is helpful in this case both to demonstrate that it is the lower income spouse’s loan and to reduce their tax), the investments must:
- Be in a taxable account (not an RESP, RRSP, TFSA)
- Have an expectation to generate income from dividends or interest (capital gains don’t count).
- That income generation does not need to exceed the cost of the loan as outlined in the spousal loan article.
Would an investment loan using your home as collateral be a useful strategy for you?
Hopefully, I have given you enough information to help answer that question. Of course, it needs to be considered in the context of being part of a cohesive financial and investment plan. This is actually a strategy that we have used and I will outline that practical application in a future post in the Sim Lab.