A Tax Planning Strategy that Still Works – And is Getting Better

Q2 | June 2020

Topic: Tax Planning

Brad Weber CPA, CA, CFP

June 11, 2020

Image used with permission: iStock/alfexe


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A Tax Planning Strategy that Still Works – And is Getting Better

Q2 | June 2020

When it comes to strategies that help you save tax, good news has been in short supply these past few years.

That will change beginning July 1st, 2020, when the prescribed rate of interest will drop from the current rate of 2% down to 1%. This interest rate applies when lending to family members for income splitting; the lower the interest rate, the better the potential for tax savings.

What is Income Splitting?

Income splitting is a strategy to reduce a family’s overall tax bill by transferring income from a high-income earner to a low-income earner. Splitting income with family members is complicated because of a set of regulations called Attribution Rules, which are designed to prevent this type of income shifting except in certain circumstances. The Attribution Rules are complex and beyond the scope of this article. But, if you follow the rules, and your situation warrants it, it is possible to achieve income splitting with a Prescribed Rate Loan strategy.

How Does a Prescribed Rate Loan Strategy Work?

Consider, for example, a couple with one individual in a high tax bracket, and the other in a low tax bracket. Further consider that there is a non-registered investment portfolio or cash available for investing. Typically, the high-income earner would be the source of savings for the investment portfolio, and the investment income earned would be traced back to the high-income earner and taxed in their hands at a high rate. The question becomes, how can you shift the investment income to be taxed in the hands of the lower-income earner? You can’t simply gift the investment portfolio to the lower-income spouse, as the Attribution Rules will prevent tax from being saved in this manner. However, if the high-income earner lends that money to the lower-income spouse, to be invested in their hands, and charges loan interest at the prescribed rate, the couple could have the investment income taxed at lower rates.

It’s important to understand that interest from the loan must be paid by the borrower and declared on the high-income lender’s tax return. The strategy shifts the excess of investment portfolio returns over the prescribed rate of interest into the lower-income spouse’s hands. Consequently, the lower the prescribed rate of interest, the more potential investment income that can be shifted to the lower-income spouse, and the greater the potential for tax savings.

Impact on Existing Prescribed Rate Loans

One of the features of this strategy is that the interest rate is locked in. This means the prescribed interest rate in effect at the time the loan is created will be unchanged over the lifetime of that loan. Any prescribed rate loan established when the interest rate was 2% will continue to stay at that rate even after July 1st, when the rate drops. It is possible to take advantage of the lower rate, but it would mean repaying the existing loan and reissuing a brand new loan at the lower rate. Most likely the current investment portfolio would need to be liquidated to generate the cash necessary to repay the loan. This liquidation might trigger capital gains; therefore, any estimated taxes should be evaluated against the potential benefits of making this change. It’s possible that recent market declines might eliminate this concern. But, that could result in another problem. If the portfolio value has fallen below the original loan value, there might not be enough cash to repay the current loan. Whatever the situation, you need to take careful consideration if you are looking to change an existing loan.

With the prescribed interest rate falling in July, now is an opportune time to consider potential benefits from an income splitting strategy. If you have cash that you are thinking about investing, this might be a way to do it more tax efficiently. As with all tax matters, things are more complicated than can be described in a few short paragraphs, so don’t rush out until you’ve consulted with your financial advisors.

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