Here’s an interesting fact: Researchers have determined that one cow produces as much greenhouse gas in one year as your car. There’s a pilot project, called Cow2, that hopes to reduce the belching of cows and reduce greenhouse gases. How? By feeding them flaxseed. The problem? It’s not going to work. I know this because I’ve tried the same thing on Carolyn and the kids.
A more successful experiment involving my family is one that I first tried years ago – and it’s working very well because it’s saving me tax every year. In fact, it’s the third pillar of tax planning: Dividing to save tax. This is the idea of moving income from one family member paying tax at a high rate, to another paying tax at a lower rate. (Read my intro to the "five pillar" series here.)
Here are four creative ideas to accomplish this dividing, or splitting, of income:
1. Make a loan and charge fair market interest.
Consider lending money to your lower-income spouse or child and charge the current prescribed interest rate (just 1 per cent until the end of March). You can lock in this interest rate indefinitely. Your spouse or child will have to pay you the interest by Jan. 30 each year for the prior year’s interest charge. You’ll face tax on this interest, but your spouse or child can deduct that cost, and will pay the tax – at a lower rate than you – on any income earned on the funds you’ve loaned.
2. Swap assets with a family member at fair market value.
If you sell assets to a spouse or minor child at fair market value, there will be no attribution back to you of income earned on those assets later. You could, for example, transfer income-producing assets to your spouse or child and take back a non-income-producing asset such as jewellery or your spouse’s half of the family home. Count the tax cost of this transfer first, and speak to a tax pro since a transfer to your spouse will require a special election with your tax return.
3. Transfer capital gains to your spouse.
You may be able to transfer 25 per cent of a capital gain – on any assets, but suppose a particular security – to your spouse (but not your children). It’ll take three steps: (1) Give one half of the securities to your spouse; (2) sell the other half to your spouse at fair market value; and (3), your spouse sells the securities on the open market.
Here’s the deal: In Step 1, there is no tax since you can gift an asset to your spouse with no taxable event. When your spouse sells the assets later, any capital gain on this half of the assets will be attributed back to you. In Step 2, you’ll sell the other half of the assets to your spouse at fair market value (he can pay for it by a promissory note, to be paid off at the end of Step 3). This sale will trigger a tax hit for you on that half of the assets. Your spouse will have an adjusted cost base on this half of the assets equal to that fair market value paid.
You’ll have to file a special election with your tax return to ensure this transaction takes place at fair market value. In Step 3, your spouse will sell all the assets with the result that one half of the gain realized is attributed back to you (refer back to Step 1), the other half will be taxed in your spouse’s hands although, because of your spouse’s adjusted cost base and lower marginal tax rate, the tax will not be as significant as if it were taxed in your hands fully.
The end result is that 25 per cent of the capital gain is shifted to your spouse. It’s absolutely critical that you visit a tax pro before trying this idea at home. You’ll want to understand any risks and make sure it’s done correctly.
4. Transfer capital losses to your spouse.
It’s possible to transfer unrealized capital losses (losses on paper) to your spouse, which can make sense if your spouse has realized capital gains in the current year or in one of the three prior years, and you don’t.
There are three steps to make this happen: (1) Sell the investments on the open market to trigger a capital loss; (2) your spouse will acquire the identical investments within 30 days; and (3) your spouse will then dispose of the investments after the 30th day.
For more details on this idea, see my article dated Nov. 10, 2011, at waterstreet.ca.