Tax Deductible Interest
a) Prescribed Loan Rates
The prescribed interest rate, set quarterly by CRA, on loans between non-arms length parties is very low. Once set, it is fixed for the duration of the loan.
Income splitting and utilization of lower income taxed family members can be facilitated through low interest loans from high income individuals to low income individuals at prescribed interest rates.
The lower income individuals can subsequently invest the loan proceeds at higher rates in the investment markets or by making loans to trusts or family controlled corporations. A spread of 5% is often available on loans thereby transferring $5,000 of annual taxable income on every $100,000 of loan amount.
b) Leveraged Investing
Interest incurred on loans for investment purposes is tax-deductible.
Loans with non-deductible interest payments should be repaid where possible with available investment funds. The investments can be replaced by funds from the loans that will have tax-deductible interest.
The advantages of using borrowed funds to purchase capital gains oriented investments can be substantial but there is also increased risk due to the possibility of losses being magnified as well as gains.
Strategy Summary
The strategy is to invest in tax deferred growth mutual funds with pre-packaged loan proceeds secured by the invested funds. Loan interest will be tax deductible. Loan payments are made monthly and may be interest only or may include principle. The following illustration assumes all loan payments represent interest payments only.
.. Enhanced Returns:
Are achieved through the used of the bank’s money with a historical loan cost that is lower than long-term mutual fund yields.
.. Reduced Risk:
Is obtained by taking a strictly long-term view with a minimum investment period of 5 years or longer to smooth out market fluctuations in returns. Directing tax savings from the loan interest expense used to increase the investment or pay down the loan will further reduce risk. However, a prolonged period of low investment returns will still reduce the overall strategy yield.
Tax Advantages
.. Conversion:
Is achieved by the loan interest being 100% tax deductible as an investment expense while capital gains are only 50% taxable. Thus, tax-deductible loan interest payments are converted in part to capital gains, 50% of which are tax-free.
.. Deferral:
Is achieved through deferring profits in the mutual fund investments until withdrawn as capital gains, and through the tax deductibility of the interest payments. This deferral can go past 69 and can be passed on to a spouse.
.. Elimination:
Is achieved through the 50% tax-free component of the capital gain
Income Tax Analysis
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