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Have Canadian Buyers Overlooked Income Splitting Advantage?

Written by Posted On Tuesday, 29 January 2002 00:00

How can borrowing from your spouse or parent save on taxes while helping you buy your own chunk of Canada?

If you earn less than another family member, you may both be eligible for income splitting, a way of lowering the overall income tax paid. The investment involved could be a cottage, income property or a combination of both.

Income splitting is the practice of transferring income from a high-tax-bracket individual to a lower-tax-bracket spouse or a child who is at least 18. The family pays less tax and therefore keeps more of the total earned income.

The Canada Customs and Revenue Agency (CCRA) generally discourages tax-saving through income splitting, but there is one opportunity that could allow you to purchase real estate and save on income tax at the same time. If the high-bracket individual makes a bona fide loan to a family member for investment purposes, income tax savings from income splitting result. When the investment is real estate, the benefits may go beyond the financial.

"It is an iffy area," says CCRA spokesperson Colette Gentes-Hawn, cautioning consumers not to get carried away trying to save taxes or they may end up paying more. "It is an area to be very careful about -- the attribution rules. Generally speaking, this must be a genuine loan. It must reflect normal commercial obligations -- interest has to be charged, a schedule for repayment of the loan must be drawn up..."

A loan is considered bona fide by CCRA if the interest rate is equal to or greater than CCRA's prescribed interest rate -- currently only 3%.

Toronto Chartered Accountant Brian Quinlan of Campbell Lawless (email: This email address is being protected from spambots. You need JavaScript enabled to view it. ), cautions that you must act before March 31, 2002 to get the full benefit of this opportunity. CCRA's rate is adjusted every quarter and this advantage may not continue.

Quinlan explains, "If a 3% loan is made to a spouse by March 31, 2002, the 3% rate is locked in indefinitely -- no matter what future prescribed interest rates are!"

To gain CCRA's approval, the family member with the lower-tax-bracket must actually pay interest to the high-tax-bracket individual within 30 days of each calendar year (i.e., by January 30 of the next year).

The lower-income individual can deduct interest paid to partially shelter investment return. The high-income lender must declare the interest earned as income, but while rates are at 3% this is a minor inclusion. The investment return above 3%, whether income or capital gain, is taxed at the rate paid by the lower-bracket spouse or child.

Here's Brian's example: Richard is taxed in the top bracket of about 46% and his wife, Fiona, at 23%. On January 1, 2002, he lent Fiona $50,000 to invest. They documented the loan stating interest was 3% and payable by Fiona no later than 30 days after the end of each calendar year.

Assuming an investment return of 6%, between them they would pay $1,035 in taxes instead of the $1380 Richard would have paid alone and they now hold a valuable investment as well. Obviously, if the investment gain is capital gain the example becomes more complex but the savings is still there.

No cash on hand to lend?

Quinlan suggests selling securities or other assets at current market value in return for a 3% demand promissory note, but cautions that the sale may trigger capital gains in your hands. In addition, the borrower will need cash to pay the 3% interest each year.

He also sees benefits for those who purchased a home with no- or low interest funds lent by their employer. Renegotiating the loan to create a new loan at 3% will limit the taxable benefit that must be included in your T4 to 3% for the next five years.

"If it is not a genuine loan, what is going to happen?" prompts Gentes-Hawn, who encourages consumers to check out their plans with CCRA in advance. (Just get any approval in writing.) "Any income or gain for the property will be attributed back to the spouse who lent the money. In every case, look carefully to make sure everything is in order."

For more details, check out CCRA Bulletin IT 511R or contact your financial advisor to go over all the tax implications of using income splitting to purchase real estate and other investments.

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