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There is plenty of advice on setting up a spousal loan for income splitting, but it’s important to know what to do when it is no longer needed.
During my working life, I transferred non-registered investment shares through a spousal loan to my wife (a stay-at-home mother). At the time of transfer, I declared the capital gain and paid the corresponding tax on the gain on the difference between the FMV (fair market value) and the ACB (adjusted cost base). We also set up additional spousal loans from time to time from savings from my executive compensation.
Now that I am retired and can split my pension income with my wife, there is no more need for the spousal loans. Should we keep the spousal loans going? She pays me the prescribed rate interest annually, and I declare this on my income annually. What is the best strategy to have the spousal loans reimbursed to minimize taxes? The market value of the investments, including non-realized capital gain now exceeds the loan amount?
I have seen advice on setting up a spousal loan for investments, but I can’t find much on the need to reimburse one and how to do so.
—Ghislain
Thanks for your question, Ghislain. I want to provide a bit of background for those readers who are not familiar with the concept of a spousal loan.
To start off, you can’t just give your spouse money to invest and then have them report it on their tax return instead of yours. If a higher income spouse does this with a lower income spouse, the goal might be to save tax, but it will not work without taking the appropriate steps.
When a spouse gives money to another spouse to invest, the resulting income and capital gains are subject to attribution, meaning that the income and gains are taxable to the gifting spouse and not the recipient who invested the money.
There are, however, exceptions if a taxpayer gives cash to their spouse to contribute to a registered retirement savings plan (RRSP) or tax-free savings account (TFSA). The attribution rules apply to a taxable non-registered account.
Spousal attribution can be avoided by loaning money to a spouse at the Canada Revenue Agency-prescribed rate in place at the time of the loan. The CRA prescribed rate was 1% for a long time before rising recently to 2% for the third quarter of 2022. The CRA rate is set to rise to 3% for the fourth quarter of 2022 because of rising interest rates.
When a taxpayer loans money to their spouse at the CRA prescribed rate, the borrower must pay interest each year to the lender. The interest is tax deductible to the borrower and reduces the resulting net investment income from the invested funds. The interest is taxable to the lender spouse, just as if they earned interest on a bond or savings account.
To the extent the borrower can earn a higher return on the borrowed funds than the interest rate, the incremental income is effectively shifted from the higher income spouse to the lower income spouse, resulting in tax savings.
You would not normally do a spousal loan for $10,000. Generally, it is for larger amounts like $100,000. Loaning $100,000 at 2% and investing it at 4% could shift the difference of 2% or $2,000 of income from one spouse to the other.
It sounds like you did things right in the first place, Ghislain, by transferring investments to your wife when the loan was established and claiming the capital gain on the disposition based on the fair market value (FMV). A spousal loan can be established using cash or by transferring investments you already own.
Once retired, it is often easier to split income by way of pension income splitting on tax returns for you both. Eligible pension income that can be split includes common income sources, like registered retirement income fund (RRIF) withdrawals after age 65, and defined benefit pension income.
If you want to unwind a spousal loan, you can certainly do so, Ghislain. It would be done the same way as paying off any other loan—by repaying the lender.
There is no “right” answer on how to do this, Ghislain, so you will need to consider all the unique factors about both your incomes and cash-flow needs.
One of the benefits of developing a retirement income plan on your own or with a professional is to try to forecast these types of things in advance, to allow as much time as possible to optimize the strategy.
Retirement planning is not just about making sure you have enough money to fund your retirement. It also involves trying to figure out the best way to decumulate your assets in retirement, pay the least amount of tax and maximize your estate for your beneficiaries.
Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto, Ontario. He does not sell any financial products whatsoever.
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I have a question about what the borrowing spouse can do with the income earned from the investments made through the spousal loan. For example, if the spousal loan generates $5000 in dividend income, could the borrowing spouse withdraw some of that $5000 to either pay the interest owed on the spousal loan or the income taxes owed on the dividend income? If they do make that withdrawal, is the interest on the entire spousal loan amount still tax deductible in the future? In that scenario, would the value of the investments need to exceed the original value of the spousal loan?
Thank you 8nadvamce for your response.
Due to the large volume of comments we receive, we regret that we are unable to respond directly to each one. We invite you to email your question to [email protected], where it will be considered for a future response by one of our expert columnists. For personal advice, we suggest consulting with your financial institution or a qualified advisor.