On July 1, 2020, the government’s prescribed interest rate dropped to 1%, which may provide a good opportunity to split income with your spouse or common-law partner, children or grandchildren, and other family members.
To split income, you would arrange for interest income to be taxed in the hands of a family member who pays tax at a lower rate than you, which may reduce the overall tax for your family. There are, however, tax rules that may prevent income splitting by attributing income or gains earned on money you transferred or gifted to a family member back to you, so you’d have to pay tax on the income or gains.
Under an exception to the rules, however, there is no attribution if you lend — rather than gift — funds at the prescribed rate and interest is paid to you by the borrower at least annually by January 30 of the following year. If this interest isn’t paid to you in this way, the attribution rules will apply even if interest is paid later.
The new 1% prescribed rate, which will remain in effect until at least December 31, 2020, is the lowest rate possible. If you make a loan at this rate and follow the rules, any investment return that exceeds 1% will generally be taxed in the hands of your lower-income family member.
For example, suppose you could invest $100,000 and earn 5%, or $5,000. If you have a 50% tax rate, you’d pay tax of $2,500 ($5,000 times 50%).
Now suppose that, instead, you lend the $100,000 at the 1% prescribed rate to your spouse, who pays tax at 20%. Here are the results
- you’d earn interest income of 1%, or $1,000, and would pay tax of $500 ($1,000 times 50%)
- your spouse could invest $100,000 to earn 5%, or $5,000, and could deduct the $1,000 of interest paid to you for taxable income of $4,000. Your spouse would pay tax of $800 ($4,000 times 20%)
- your combined tax bill would be $1,300 ($500 plus $800), which is $1,200 less than the $2,500 tax that you’d otherwise pay.
You can also use this strategy to help fund children’s expenses, such as paying for private school and extracurricular activities, by making a prescribed rate loan to a family trust, with the children as beneficiaries.
Although the prescribed rate varies by quarter and may ultimately rise, you need to only use the prescribed rate that is in effect when you make the loan. If you previously loaned funds to a family member when the prescribed rate was 2% or higher, and wish to take advantage of the new, lower rate, your family member should sell the investments (being mindful of any tax consequences) and repay the original loan. You can then enter into a new loan agreement using the 1% prescribed rate.
Unfortunately, you cannot simply adjust the rate on the original loan or refinance the loan at 1% by repaying the original loan with a new loan.
Be sure to speak with your tax and legal advisors to determine whether a 1% prescribed rate loan could be suitable for you.