A Prescribed Rate Loan Could Help You Save Taxes – Act Now Before The Rate Doubles!

Piggy bank poster

Topic: Tax Planning

R. Denys Calvin, CFA

February 6, 2018

Image used with permission: iStock/macrovector


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A Prescribed Rate Loan Could Help You Save Taxes – Act Now Before The Rate Doubles!

With the Federal taxation authorities laying siege to one income-splitting technique after another in the last couple of years, one that remains untouched is the so-called “prescribed rate loan”. In its most typical incarnation, the PRL involves a high-income earner lending to his/her low-income spouse.

The low-income spouse then invests the loan proceeds, with the resulting investment earnings being taxed in their hands, rather than in the high-income earner’s hands. This technique works as long as the interest rate paid on the loan by the low-income spouse to the high-income earner is not less than the “prescribed rate” prevailing at the time the loan was made (and provided interest on the loan is paid within 30 days after each year end).

For 9 years, except for a 3-month “blip”, the prescribed rate has been a meagre 1%. Consequently, if a low-income spouse invested PRL proceeds and earned 5% annually, 4 of those 5 percentage points of return — 80% of the investment income — would have been taxed lightly in the hands of the low-income spouse, rather than heavily in the hands of the high-income earner. Clearly, the lower the prescribed rate, the lower the interest on the loan, and the greater the tax savings for the income-splitting couple.

Alas, the prescribed rate is not fixed. It is set by the Federal government each quarter. The formula used to set it is no state secret. It’s equal to the whole percentage rate nearest to, but not less than, the average of the 91-day Treasury bill auctions in the first month of the preceding calendar quarter. While the prescribed rate for the second quarter of 2018 won’t be announced until sometime in March, it is a mathematical certainty that it will be doubling — from 1% to 2% — because of the rates set in the T-bill auctions on January 9th and 23rd. Moreover, this uptick in the prescribed rate seems destined to persist. With central banks the world over seemingly determined to throttle back on the extraordinary monetary stimulus of the last 9 years by, among other things, raising interest rates, the prescribed rate is unlikely to go back down to 1% any time soon. Indeed, it will probably rise further in the future.

So, those who could use a PRL arrangement to save taxes should not delay. Loans made on or before March 29th will lock in the 1% prescribed rate and will reap bigger tax savings than those made after. RDC

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