What is a spousal loan?
A spousal loan is exactly what it sounds like: one spouse (legally married or common law) lends the other funds. Using this type of loan is a strategy to save income tax. It does so by splitting income, in this case investment income. The loan is a “proper” loan in that the lender (the higher-income spouse) charges the borrower (the lower-income spouse) interest. Because of that, normal attribution rules do not apply and investment income is taxed in the hands of the borrower at their lower marginal income tax rate.
The same income-splitting approach can be used to reduce overall family taxes by lending money to a minor child.
How spousal loans work
If you simply give funds to your spouse to invest, or lend the money interest-free, any returns on investments made with that money will be attributed back to you and taxed at your rate. Charging your spouse interest on the loan means these attribution rules do not come into play. For this strategy to work, then, the investment returns on the borrowed funds must obviously be greater than the interest rate charged, because the lending (higher-income) spouse must pay income tax on the interest received for the loan. But note as well that the borrowing spouse can take advantage of the income tax deduction for investment costs in relation to the interest they pay.
The federal government sets out the interest rate, called the prescribed rate; you must charge interest at that rate or higher. As of 2017, the rate is 1%. If the prevailing commercial loan rate is lower than the prescribed rate at the time you arrange the loan, you may use the commercial rate. The family member who borrows the funds must pay the interest by 30 days after each year-end. But there are no regulations or requirements for paying back the principal amount of the loan.
The interest rate stays the same for the duration of the loan. That means that the best time to take advantage of this strategy is during a period of low prevailing interest rates: you can lock in a low interest payment, then hold the loan in investments through higher-interest periods.
If you had set up a spousal loan in the past, when rates were higher, you can still take advantage of lower rates today. To do so, the loan must be repaid. (Note that if you must sell some of the investments to repay the loan, the lower-income spouse may have to pay capital gains tax on the proceeds, so work this into your calculations.) Then, set up a new loan at the current lower interest rate and purchase new investments.
To formalize an income-splitting loan to your spouse or child, draw up and sign a promissory note specifying the principal loan amount, the interest rate and the date. Check the Canada Revenue Agency’s website for the prescribed interest rate at the time the loan is set up.
Who can use this strategy?
Spousal, or family, loans can work for a family that has a high income earner and a low income earner. This strategy works best if you have a significant amount of non-registered funds to invest – little tax is saved if less than $100,000 is loaned and invested. You will need to choose investments that have expected returns that are higher than the prescribed interest rate so you must be willing to accept that level of risk.
A few cautions
If one spouse were to pass away with a spousal loan in place, the loan must be treated the same as any other estate debt: if the borrower dies, unless the will states otherwise, their estate must pay back the loan. If the lender dies, their estate must collect the debt, before any estate assets are distributed. If the surviving lending spouse forgives the loan, there will be tax consequences.
If the relationship breaks down while a spousal loan in in place, the lending spouse may call in the loan. When assets and liabilities of the marriage are divided, the loan itself should not have a significant impact on the couple’s overall finances, but the division of the investments could affect the parties’ taxes.
As with all tax and investment strategies, your personal circumstances must be examined to ensure a spousal loan is right for you. Talk with your investment advisor and accountant before setting up a spousal or child loan to make sure it is to your advantage.