Last week I wrote about gifting and lending money to your kids. Today, I want to finish off that discussion.
Loans to freeze values.
An “estate freeze” is the idea of passing the future growth of assets to someone else – often your kids – so that, among other benefits, you won’t pay the tax on that future growth. If you lend money to a child and he or she grows that money, your child will generally pay the tax on that growth (there may be exceptions where the taxman concludes that one of the main purposes of the loan was to minimize tax in your hands). When that future growth is owned by, and is taxed in, your child’s hands, you will have effectively achieved a type of estate freeze.
Loans accompanying a sale.
If you sell an asset to your adult child for fair market value and take back a loan as consideration for all or part of the sale price you’ll generally avoid any negative tax consequences related to the loan. Keep in mind that a sale of any asset at fair market value, where that asset has appreciated in value, could trigger a taxable capital gain in your hands.
Loans that earn second generation income.
If you lend money to a child who uses the proceeds to earn income from property (including interest, dividends, rents or royalties) that income will be attributed back to you if the child is a minor. Second generation income – that is, income on the income – will not be attributed back to you.
Loans by U.S. persons.
If you’re a U.S. citizen, resident, or a green card holder then you have to be aware of U.S. gift and estate tax laws. If you’re thinking of helping your children financially and you prefer a gift you could be subject to U.S. gift taxes unless the gift is below the annual gift tax exclusion (currently $13,000 per year per beneficiary) or you utilize all or part of your lifetime gift tax exemption ($5.12-million in 2012, but due to drop to $1-million in 2013), which will have implications on the amount of estate tax you could pay at the time of death. A loan will avoid a gift tax problem. A visit to a tax pro will be important if you’re a U.S. person.
Loans to kids outside Canada.
If your child lives in the United States or elsewhere and you’re planning to make a loan to him or her, ask a tax pro about subsection 247(2) of our tax law. This subsection could apply to a loan to a non-resident child. If so, there will be a deemed, or imputed, interest amount in your hands, which will be taxable to you. The good news is that the taxman has not been in the practice of assessing taxpayers under this subsection for loans to kids. Keep in mind, however, that the subsection could apply. Gifts to your kids outside Canada could avoid this problem.
Indirect loans and guarantees.
If you try to sidestep the attribution rules in our tax law by lending money to a person who in turn lends to your minor child (or a trust for him), the loan will be treated as though it was made directly by you. Further, if your minor child (or a trust for him) borrows money from a financial institution or other third party and you guarantee the loan, the loan will be considered to have been made directly by you.
If you do lend money to your child and he or she repays you (good luck with that), there are no negative tax consequences. If your child, however, makes a gift to you over and above the principal amount of the loan, perhaps to compensate you for use of your money, beware that the taxman will generally take the view that the gift was an amount received by you “on account of, or in lieu of, or in satisfaction of interest.” If this happens, you could end up paying tax on that “gift” as though it was interest income.
Loans to minors.
Finally, since a minor cannot enter into a loan agreement, lending money to your minor child must generally be done by lending money to a trust for your child.