Parents often lend money to their children to help with the purchase of a major personal or consumer item. A common example is a loan to help with the purchase of a child’s first home.
Generally, there are no problematic tax issues for these loans to adult children. (A loan to a child under 18 generally triggers the “attribution rules”, which we have discussed in other Tax Letters.)
If you are paid interest, you are required to include the interest in income. The child cannot deduct the interest on a personal loan. However, if they use the loan for investment purposes — say, to buy a rental property instead of a personal residence — they can deduct the interest they pay you.
An interest-free loan used for personal purposes by your child poses no tax problems. However, if the interest‑free loan is used by your child for investment purposes, there is a special attribution rule in the Income Tax Act that may apply (subsection 56(4.1)).
This attribution rule can apply if “it can reasonably be considered that one of the main reasons for making the loan… was to reduce or avoid tax” by causing the resulting investment income to be included in the child’s income rather than your income. This rule might apply if you are in a high tax bracket and your child is in a low tax bracket and one of the main reasons for the loan was to shift investment income into your child’s hands to reduce overall tax. If this was the case, the investment income may be attributed to you and included in your income. The Canada Revenue Agency does not often apply this rule, but it is an important rule to remember because it can be applied.
The attribution rule does not apply to capital gains of your child if they sell the investment. It can only apply to income from property, which includes interest income, dividends, and rental income.
One way to avoid the attribution rule is to charge interest at the prescribed rate under the Income Tax Act at the time of the loan. This rate is typically low, as it is based on 90‑day Federal Treasury bill rates. For example, throughout 2021, the prescribed rate was 1%. At the time of writing, the prescribed rate for the first quarter of 2022 had not yet been announced.
Forgiving the loan
Where the loan is used for the child’s personal purposes, if you subsequently forgive the loan, there are no income tax consequences for the child. The forgiveness is basically treated like a gift, which is similarly tax‑free for the recipient of the gift.
However, if the loan is used by the child for investment purposes (or business purposes) and you subsequently forgive the loan, there can be adverse tax consequences for the child. In general terms, the amount of the forgiveness will reduce some of their tax attributes or tax costs, such as their non‑capital or net capital loss carry-forwards and / or the cost of their depreciable or non‑depreciable capital properties. If there is a remaining amount left after these reductions in tax attributes or tax costs, your child will usually be required to include half of that amount in income.
The forgiveness rules are complex; the above is a very general summary. We will discuss the rules in more detail in a later Tax Letter.
Exception: Forgiveness under your will or bequest
If the loan to your child remains outstanding upon your death, and it is settled or forgiven under the terms of your will or otherwise as part of a bequest or inheritance for your child, there are no income tax issues. In particular, the debt‑forgiveness rules do not apply to loans that are settled in this manner upon death, including loans used for investment or business purposes. The rationale for this rule is that the forgiveness is basically treated as an inheritance, and in Canada inheritances are not subject to income tax for recipients.