As we head into the second quarter of 2012, the unprecedented run of historically low prescribed interest rates on spousal loans continues. Based on the relevant t-bill auction in January, the 1% rate will be available until at least mid-year.
For spouses who remain on the precipice of establishing such a loan, it occurred to me that a closer look at RRSP earned income could push them over that edge. Specifically, what further benefits might the couple gain where the borrowing spouse deploys the invested money into rental real estate?
Spousal loans
The spousal income attribution rules cause passive income on gifted funds between spouses to be attributed to the benefactor spouse. The rules apply only to the initial income, which is to say that income-on-income or ‘second generation income’ is that of the receiving spouse.
Attribution will not apply at all however where the receiving spouse has provided fair market value assets for the subject funds or where the spouses have entered into a bona fides loan arrangement.
If a loan is used, the interest rate must be no less than the prescribed rate, and must be paid from the borrower’s own resources no later than January 30 following each calendar year the loan is outstanding. The interest payment is income to the lender and a deduction for the borrower.
So how might a spousal loan assist a spouse’s RRSP?
Spouse’s RRSP
To be clear, I am not referring to a contribution (and deduction) by a high income earner into a spousal RRSP. No doubt that avenue will have been canvassed and employed as a first step in tax-managing the couple’s wealth. Rather, this is a subtler approach that attempts to bolster the tax efficiency of the receiving spouse’s contribution to the household wealth.
Despite being a lower income spouse in a relative sense, that characterization does not mean that he or she is at the lowest bracket level. Accordingly, the receiving spouse may him/herself still wish to make use of RRSP contributions as a means of reducing current income in anticipation of being in a lower bracket in future retirement years.
Connection to ‘earned income’
Most people would consider their entitlement to RRSP room to be inextricably tied to their employment income. Principally that would be true for a large part of the population, but the definition of earned income (upon which the room is based) is much broader than that, including:
- Royalties from authorship or invention
- Net research grants
- Unemployment benefit plan payments
- Wage loss replacement plan benefits
- Proprietor/partner active business income
- Qualifying support payments received
- CPP/QPP disability pensions
- Net rental income from real estate
Thus, borrowed money that is devoted to rental real estate investment can serve the dual purpose of generating income taxable to the receiving spouse, and increasing that person’s RRSP contribution room. While a similar effect may be achieved where borrowed funds are placed in an active business, that obviously requires someone of an entrepreneurial bent to carry out.
Back to our real estate application, it is critical that the loan be properly documented and conscientiously serviced. Should the loan fail to qualify in a future year, not only will that income be attributed to the lending spouse, but also the related entitlement to RRSP room. Given that presumably the higher income spouse will already be maxing RRSP contributions, the couple will then lose out in both respects.