Par Brad Berry, CPA, CA de Mowbrey GIL
Before we get into whether or not a prescribed rate loan is right for you and your family, we should answer the question as to what a prescribed rate loan is. A prescribed rate loan is a loan made from a higher income earning spouse to a lower income earning spouse, adult family member, minor child or family trust at the “prescribed rate of interest.” The use of such a loan can transfer income from a higher income earner to a lower income earner, tax the income at lower tax rates and reduce the family’s overall tax burden.
Now let’s assume the Taxpayer makes a loan of $500,000 with interest at the current prescribed rate of 1% to a spouse, child or family trust. The funds are invested and earn a return of 5%.
In this case, the loan recipient has investment income of 5% or $25,000 and incurs interest expense of 1% or $5,000. The net investment income of $20,000 will be taxed at their respective tax rate. Assuming this is 25%, the taxes payable by the spouse or child would be $5,000.
In addition to this the Taxpayer has investment income of 1% or $5,000 that is still subject to tax at 48% or $2,400. The total taxes are reduced from $12,000 to $7,400. This would result in tax savings of $4,600 annually. As the investments grow and the return increases these savings will increase exponentially.
Currently, the prescribed interest rate is at 1%, but is expected to increase to 2% on July 1, 2022. Where a loan is established before July 1, 2022, the lower 1% prescribed interest rate will apply as long as the loan stays in good standing.
To ensure that a prescribed rate loan is set up properly:
- It is important that the interest on the loan be paid no later than 30 days after the end of the calendar year; and,
- The loan be documented with repayment terms or as a demand loan.
With the increase in the prescribed rate coming on July 1, 2022 now might be the time for a prescribed rate loan!