## The clock is ticking on a spousal loan strategy

Are you in the top tax bracket? Is your spouse in a much lower tax bracket?

More than two years ago, Canada Revenue Agency gave some Canadians a gift - although many haven't taken advantage of it. The gift is still in place today, but I suspect that will change in the next three to six months.

The gift from Canada's taxman looks like this. As of April 1, 2009, the CRA allowed Canadians to make a loan to a spouse at 1 per cent a year, with the rate being locked in for the life of the loan. The rate is based on a prescribed rate the CRA issues each quarter.

A spousal loan makes sense in the following two cases:

1) An individual who has non-registered investments in their own name - probably at least \$100,000 to make the strategy worthwhile, or someone who has sizable assets in a joint account.

2) The spouse that doesn't hold the investments (or one of the joint account holders) has a low income or no income, while the other spouse is in or near the top tax bracket.

The loan is quite easy to put in place with minimal cost, but could save thousands in taxes every year.

Here is an example: In this case, Spouse A has employment income of \$200,000 a year and Spouse B has none. Spouse A has non-registered investment assets of \$400,000.

 Status Quo Spouse A Spouse B Employment Income \$200,000 0 Non-Registered Investments \$400,000 0 Assume 6 per cent gain or \$24,000 on investments (2 per cent interest, 2 per cent dividend, 2 per cent capital gains) Total after tax income for the couple (in Ontario) \$142,996

In the second scenario:

 With a full spousal loan of \$400,000 Spouse A Spouse B Employment Income \$200,000 0 Non-Registered Investments 0 \$400,000 Tax on 6 per cent gain (2 per cent interest, 2 per cent dividend, 2 per cent capital gains) Total after tax income for the couple (in Ontario) \$146,776

This exampe shows that the benefit of a \$400,000 spousal loan is \$3,780 a year. If you don't think that sounds like much, look at it over the long term. Setting up a spousal loan at 1 per cent could be worth \$100,000 in tax savings over 27 years.

Why it works

In the above example, Spouse B is taxed at their low rate on all of the income and capital gains from the portfolio. Spouse B must pay 1 per cent or \$4,000 a year to Spouse A. Spouse A must claim the \$4,000 as interest income, but Spouse B can deduct the interest expense.

This interest cost and deduction is really the only cost of the loan. In this case, the 1 per cent loan interest is paid to Spouse A and at 46 per cent marginal tax, it costs the couple \$1,840 in extra taxes (\$4,000 times 46 per cent tax). However, they also are able to write off the \$4,000 in interest costs from Spouse B. Because Spouse B is only taxed at 20 per cent, they are only able to write off \$800 of the loan interest. The net impact of the extra tax minus the tax that can be written off is \$1,040. In this case, that is the true cost annually of the spousal loan.

In the example, it looks as though there was about \$4,820 in tax savings, as the net savings was \$3,780 AFTER the extra \$1,040 in tax expenses.

To better understand why 1 per cent is a gift, keep in mind that in 2007, the rate was 5 per cent.

At 5 per cent, instead of this being a net benefit of \$3,780, the spousal loan becomes a net cost of \$2,147 when I ran the numbers. At 5 per cent the cost of the loan becomes too big a hurdle to overcome through the tax savings.

If you actually did a spousal loan in a year when the interest rate was higher than 1 per cent, you can pay off the loan and simply do a new one. This will lower your loan rate to 1 per cent.

How do you make a spousal loan?

1) Spouse A must actually lend cash to Spouse B. There must be documented flow of cash from an account in Spouse A's name to Spouse B. If Spouse A is holding stocks, they would have to liquidate them first, and then do the loan. If this causes great cost due to capital gains taxes or transaction costs, then maybe you don't pursue the loan. This must be reviewed first. Spouse B must invest the funds in order to make the loan make sense. It is the expected gains from this cash that makes the Spousal Loan strategy work.

2) Spouse A writes a loan note with a stated rate of interest, the prescribed rate at 1 per cent, and as long as your Spouse B pays Spouse A the interest on the loan, from their own funds, within 30 days of the end of each year.

As long as you make a proper paper trail and pay the loan interest each year, you can maintain the 1 per cent interest rate for as long as the loan is in operation. When it stops making sense, Spouse B would simply pay back the loan.

While it is impossible to guarantee above average investment returns, strategies like the spousal loan arrangement at 1 per cent are part of a strong financial plan. By taking advantage of good ideas when they come along, you will increase your odds of doing well over the long term. Don't wait until it is too late and CRA raises the prescribed rate.

Ted Rechtshaffen is president and CEO of TriDelta Financial Partners, a firm that provides independent financial planning advice. He has an MBA from the Schulich School of Business and is a certified financial planner. He was vice-president of business strategy at a major Canadian brokerage firm.