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An understanding of interspousal transfers and attribution rulesmay at first be intimidating. However, a little time spentunderstanding the rules reveals many planning opportunities. TheCCRA Interpretation bulletin # IT-511R is 35 pages long and aperfect cure for insomnia. If you can get through it, you willfind other ideas on how to help your client while staying withinthe spirit of the rules.
For new clients that come to you with prior unrealized lossesthe gain can be realized and the proceeds from the investmentapplied to any non-deductible debt. After thirty days the clientcan repurchase the investment if desired form funds acquiredfrom new borrowing and thus have the cost of carrying theinvestment tax deductible. The realized loss can also be carriedback up to [link widoczny dla zalogowanych] three years to be applied against prior capitalgains. Recent rulings by the Supreme Court of Canada havereinforced the rules about the deductibility of loan interest.
Many lenders will want to treat an equity take out mortgage as ahigher risk second mortgage, or they may try to have it CMHCinsured at an added cost to the client. If the clients existingfirst mortgage and new second mortgage are in total less thanthe 75% of the appraised value of the home then fist mortgagerates apply and CMHC insurance is not required. This is animportant negotiating point, which the client on their own isusually not up to arguing with the bank. As the advisor you cancalculate an accurate loan to value ratio (LVR) and be thenegotiator with the lender. In fact our loan proposal form showsthe rate and terms we are looking for. So the lender knowsbefore they even get back [link widoczny dla zalogowanych] to us what we expect from them. Afteryou have done a few deals with a lender and they have found yourinformation to be credible, they quickly get to know what youexpect if they want your referrals and the your client'sbusiness.
There are many variations for income splitting, both deductibleand non-deductible, including reverse attribution. For childrenremember that capital gains do not attribute back to the parent.There is no attribution to parents on income reported by anadult child.
An obvious advantage to the advisor is additional fee revenuefor this service, or the placement of the investments dependingon the nature of the engagement with the client. However, themore important advantage is in protecting the client fromover-zealous loan officers. Often the bank or other lendinginstitution will want a higher rate of interest then will bewarranted, or they try to make the loan appear that it isdependent on the customer bringing other business to the bank,or investing the borrowed funds with them. Tied selling isagainst the law but is seldom prosecuted by the [link widoczny dla zalogowanych] regulators whofear doing their job and offending the big banks. As it is nevergood business to hold your assets at the same place that hasyour debt we can protect the client from that. If anyone thinksthat a [link widoczny dla zalogowanych] financial institution will not grab a client's assets,registered, or not when they want to pay down their loan, justask around.
Summary We have found that even the wealthy like to use leverageto invest [link widoczny dla zalogowanych] even if they do not need to accumulate more assets. Itis for some, just part of the game of wealth accumulation. Forothers it gets them to where they want to go faster. For theadvisor it is a powerful tool to get the client to where theywant to go. Everyone knows that any portfolio that can go up 20%or more in a year can also go down 20% or more in a year. Thetrouble of course is that the loan still needs to be repaidregardless of the value of the portfolio. Although leverage canbe a high risk if not handled properly, arranging the debtproperly can minimize the risk to the client. By starting smallif necessary, the client can get comfortable with the processand still have funds elsewhere for use when needed. The largerthe loan the more important it is to protect the client againstmargin calls, or calls on a demand loan. Choosing the correctinvestment mix for the portfolio is very important. Coordinatingthe proper terms of any borrowings is just as important a partof your fiduciary responsibility to the client. Used properly,leverage can be a great tool for you to help your client reachtheir goals.
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Using Debt To Achieve Other Goals Often the client is willing toundertake a leverage-investing program if it helps them reachanother goal that may be more important to them. For instancemany seniors find the Clawback [link widoczny dla zalogowanych] of their Old Age Security (OAS)to be very upsetting to them. If after all of the other incomesheltering methods have been used, the client will still beexposed to clawback, leverage can be very appealing to them.Interest paid to purchase investments is of course deductiblethe year it is paid. This reduces their net income and can putthem back on the receiving end of the OAS. By lowering theirincome with the use of leverage they increase their eligibilityfor other government programs, which are income related, such ashealth care and home-care costs.
Registered Retirement Savings Plans (RRSP) loans have beenaround for a long time and are popular in Canada with thosepeople who can't seem to get ahead and start on a Pre-AuthorizedCheque (PAC) program. The rates are quite low and the loan canbe paid off quickly if the client has the fortitude to apply thetax refund to the RRSP loan balance. I have always advocatedone-year RRSP loans. But in some cases a client with a largeunused contribution room can do some major debt refinancing byuse of a large RRSP loan and perhaps a longer payback period ifnecessary. Some interesting scenarios can be developed torestructure non-deductible debt. A simple example is a clientwith 10,000 of credit card debt and 20,000 of contribution roomwho takes an RRSP loan for 20,000 in February. The tax refund ata 47% marginal rate would be $9,400.00 to be received within afew months. That plus the regular payments for a couple ofmonths until the refund arrives should be sufficient todischarge the debt. Of course the client has to make payments onthe RRSP loan for the year, but the interest cost on the debt iscut almost to a quarter of the credit card rate and within ayear they are debt free. It also prepares the way for them topay of future charge card balances each month.
There is some truth to the old saying that: "A bank will onlyloan you money when you can prove that you don't need it."However an experienced advisor that believes leverage is rightfor their client can usually arrange for the funds. For theclient that does not have a lot of assets for collateral, orroom for very much debt servicing, a monthly saving programshould be considered if debt re-financing is not workable. Thereare many programs on the market that will loan [link widoczny dla zalogowanych] one dollar forevery dollar invested thus starting a leverage program on asmall scale, but almost doubling the clients' investmentpotential. But read the fine print in the loan agreement. Keepin mind that the same potential for gain has a potential forloss as well. However, by investing for the long term that riskcan be minimized.
Income Splitting is probably the greatest benefit that can beachieved with debt. Where the client's goal in the long term isincome splitting, a leverage loan by the higher income earnerwith a low interest rate to the lower income spouse can helpachieve the goal. It is important that interest at theprescribed rate, or a commercial loan rate at the time the loanis made, be paid with thirty days of the end of each year inorder to avoid the attribution rules. A promissory note shouldbe in writing to [link widoczny dla zalogowanych] evidence the legal obligation to pay theinterest. With the current low interest rate environment it isan ideal time to consider a loan to a lower income spouse, so asto lock in a low interest rate for a long period. In this casethe loan paid by the spouse is a deductible expense to the lowerincome spouse. Even though the [link widoczny dla zalogowanych] investments may be held in JointOwnership for estate planning purposes it need not affect theinterest deductibility if the loan and investment transactionsare well documented.
Even using a life insurance policy as collateral for the loanentitles the borrower to a much lower interest rate at a bank,while freeing up capital for other purposes. But, mainly it canavoid any taxation resulting from borrowing directly form theinsurer, or cashing out the policy and triggering an incomeinclusion for the year. Even though an old life insurance policymay have a low guaranteed loan interest rate, a large loan willusually produce a tax slip at the year-end for the amountborrowed in excess of the cost base. Many people are verysurprised when they inquire as to the cash value of their oldlife insurance policies if they have also been reinvesting thedividends or using them to automatically buy paid up additionalinsurance. The problem is that many of these old policies have acost base near zero. The loan cost may become deductibledepending on what the funds are used for. But by using them ascollateral they can use the funds for other purposes and leavethe loan in place to be paid off from their estate with thetax-free proceeds from the life insurance policy.
Negotiating Debt For Your Client Some of the leverage programsavailable to the advisor are highly structured and easy to use.However, I have found that better deals can be made with betterterms for the client. We have made it a practice to submit theloan application ourselves on our own forms to a lendinginstitution we have worked with for our clients, or to submitthe application to the client's bank, or both. I have found thatlenders find the clients of a financial advisor to be their mostdesirable type of client. This is partly because an advisorsclient's are high income, or high net worth, or at the veryleast responsible and determined to get ahead.
For many years we have used second mortgages to help ourchildren and client's let the kids get into their first home.These are participating mortgages at zero percent interest drawnfor the percentage the loan bears to the purchase price. So ifthe parents loan the kids 10% of the purchase price of the home,they receive 10% of the proceeds when it is sold. However, forthe kids it allows them to get into a home sooner, does notaffect [link widoczny dla zalogowanych] their debt servicing ability, protects the capital in theevent of a marriage breakdown and allows the parents to have aleveraged investment without any annual income to add to theirtax until the property is sold. For another article on thissubject: Click Here
Borrowing To Invest With No Tax Relief Often debt can be used tomeet other financial planning [link widoczny dla zalogowanych] situations even if there is no taxrelief. The obvious is of course debt consolidation, or theraw-land example mentioned earlier. However there are many otheropportunities worth considering. One common example is aparent(s) who want to help their children but the children arenot financially responsible enough, or they do not have any debtservicing room. Often parents are reluctant to give up capitalfor fear they may need it later in retirement. They may besitting on a lot of equity in their portfolio or their homes,which they are not using. Taking a loan in their name and buyinga portfolio of investments in their name in Joint Ownership withtheir adult child has some interesting uses. Firstly, juniorcannot cash the investment without the parents blessing. In thiscase, at least half of the loan interest could be deductible.The estate can pay off the loan at death. The portfolio willpass automatically, without probate to the adult child at theparents' death. The value of the portfolio can be deducted fromthe child's share of the inheritance as per the will. Theportfolio can even have the income paid to the adult child ifthe parents want to help out without giving up the capital. Ifjunior is in bad shape financially, or he already has numerousloans, mortgages, or credit card balances, this can help whilestill protecting the parents. This arrangement need not be apart of the matrimonial assets if juniors' marriage breaks up.
Although a client's non-deductible debt is a financial plannersworst nightmare, there are cases where it can be used to meetsome of the client's wishes.
For the same reasons, the client can take a loan or a mortgageto help their favourite charity. In some cases servicing theloan is more attractive than using their own capital and mayhave immediate tax benefits. In cases where the clients' do notwant to use their own assets for fear of triggering a capitalgain the loan route has some advantages. If the asset with acapital gain is a listed security it may now be advantageous todonate the listed security to [link widoczny dla zalogowanych] the charity directly so as tobenefit from the new 25% inclusion rate. If they do not want torealize any capital gains then a loan could be the answer. In ayear of unusually high income, a sizable tax deduction can solvea lot of problems and help the charity at the same time. Payingoff the loan from their eventual estate also reduces the netestate subject to probate fees.
In some cases we are also negotiating loans that are not securedby the client's home. But the equity take out mortgage is ourfavourite because it does not require a personal guarantee andusually carries a much lower borrowing rate. Our work can beseen as financial advisor, debt consultant and then investmentadvisor. In either case, our fee is deductible to the client forthis service in addition to any application fees, appraisalcosts, etc. which they may be required to pay.
Reverse mortgages are another example of non-deductible debtthat can on occasion be the right answer for unique situations.We have used this in the past where a client does not want todownsize, but needs additional income
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