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Spousal loans – A tax strategy for investors in a low-interest economy

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Interest rates have been at historic lows for years now, which may have investors wondering whether there is any way to exploit this – in a legal way. A strategy that thrives in this environment is to set up a spousal loan designed to reduce the household tax bill. Here’s how it works.

As background, individually we are taxed at progressively higher tax rates as our income rises. This gives us an incentive to try to split income with a spouse who is at a lower tax bracket, for example by giving money to your spouse to invest in a non-registered cash account. Not surprisingly, the tax system anticipates such maneuvers, and attributes such investment income back to the higher income taxpayer.

But while a gift to your spouse is a problem, a properly structured loan will allow you to circumvent the negative tax effects.

To qualify, interest must be charged on the loan at a minimum rate dictated by tax regulations, known as the ‘prescribed rate’. It is calculated based on economic conditions in the calendar quarter when the loan is established, and presently stands at 1% through the end of March 2018.  This prescribed rate will rise to 2% on April 1, 2018 so candidate-spouses need to act before that date to lock-in the 1% rate, as further described below.

The investment income goes to the lower income borrowing spouse, less a deduction for the interest paid. On the other side, the lending spouse will have to include the interest in income. Even so, assuming investment returns in excess of the interest rate (especially when the rate is 1%), the expectation is that the net result will be less tax due.

What makes this strategy particularly appealing is that you can keep the loan outstanding indefinitely at that original interest rate, even if the prescribed interest rate rises in future. To preserve that original rate, interest payments must clearly come from the borrower’s resources. As well, the interest must actually be paid, either during the calendar year or within 30 days afterwards.

With careful structuring and recordkeeping, the use of a spousal loan can be a legally effective means to split income and reduce taxes on a portion of your investment portfolio.

Speak to your Meridian Wealth Advisor for perspective on these important issues.

Meridian Credit Union communications are intended for informational purposes only and do not constitute financial advice or an opinion on any issue. We would be pleased to provide additional details or advice about specific situations if desired.

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