What tax implectations are when giving financial gifts or loans to your children.

One of the more common questions that come up in our office is “How much can I gift to my kids without triggering taxes?”  Keep in mind that there are very different rules for “gifting” when it comes to US taxes, and I won’t touch on that in this article. If you want to know more related to US taxes and gifts, I encourage you to reach out to our resident US Tax Expert – Tyler Pocsik – he will be happy to answer questions related to US tax. 

Perhaps the most common situation for the question above is when parents are helping with the purchase of a child’s first home.  Generally speaking, there are no tax issues for loans to adult children (loans to children under the age of 18 will trigger “attribution rules”).

If there is interest charged on the loan, the parents must include this interest as income on their personal tax returns.  The child cannot deduct the interest since this is a personal loan (used for non-investment purposes).  However, if the situation was slightly different and the loan was used for investment purposes (say to buy a rental property rather than a personal residence), the child can then deduct the interest paid to the parents.

What if you choose to not charge interest on the loan to your child?

  • An interest-free loan used for personal purchases (personal residence, car, etc.)  causes no tax problems at all.
  • An interest-free loan used for investment purposes (rental property, stocks, etc.) triggers special attribution rules,

This attribution can apply if “it can reasonably be considered that one of the main reasons for making the loan…was to reduce or avoid tax” essentially by moving income-earning assets from the parents to the child. 

This (unacceptable) “tax strategy” is due to the marginal tax rate system in Canada.  As income increases, the tax rates increase, causing higher levels of tax.  So it makes sense that parents would be motivated to move income-earning assets to their children, who presumably have lower levels of income which would be taxed at lower marginal tax rates.  If this “tax strategy” was implemented by a family, the attribution rules move the investment income back to the parents where their higher marginal tax rates would apply.

It is worth noting that the attribution rules do not apply to capital gains to the child if they were to sell the investment.  The rules only apply to income from the property, including interest income, dividends, and rental income.

Ok, so the attribution rules apply to interest-free loans.  We can avoid these particular attribution rules if charge interest at the prescribed rate under the Income Tax Act at the time of the loan.  At the moment, the prescribed rate is 1%.

So we’ve covered both interest-free loans and interest-bearing loans, but the original question had to do with gifting amounts to our children.  Assuming we start with a loan that is used for personal purposes, and then subsequently forgive the loan, there are no consequences for the child.  The loan forgiveness is basically treated like a gift – the amount is a tax-free receipt for the child.

However, all of this gets a bit messy if the loan forgiveness (or gift) applies to a situation where the funds are used for investment purposes.  In general terms, the amount of the forgiveness will first reduce certain tax attributes for the child, such as non-capital or net capital loss carryforward balances, and/or the cost of any depreciable or non-depreciable capital properties.  If there is a remaining amount left after reducing these tax attributes, the child will then have to include half of the loan forgiveness amount in their income.

And to keep you on your toes, let’s toss in one more exception to these loan forgiveness rules (did I mention that the Income Tax Act is complex?!?!)  If the loan to your child remains outstanding upon your death, and the loan is settled or forgiven through the will, there are no income tax issues.  The idea here is that forgiveness is basically treated as an inheritance, which is not subject to tax.

Keep in mind these rules are very complex and the above is a very general overview of those rules.  Please reach out to discuss your specific situation in more detail. Remember,  JMH & Co. is your partner for financial success!

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