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6 | INVESTMENT EXECUTIVE NEWS June 2020 Borrowing to invest should always involve caution
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scribed-rate loans, investing on margin or ensuring access to credit, clients are looking for advice on how they can best take advantage of low rates while navigating volatile markets.
“For a lot of investors, the opportunity is now,” says Carol Bezaire, vice president of tax, estate and strategic philanthropy with Mackenzie Investments in Toronto, referring to the use of margin investing, where appro- priate, for clients.
Says Jason Heath, managing director and certified financial planner with Objective Financial Partners Inc. in Markham, Ont.: “Everything from rental real estate investing to leveraged insurance strategies to borrow- ing to invest in stocks — you’re going to see more of that.”
Economists with Canada’s big banks expect today’s low rates to stick around. Forecasts are for the Bank of Canada to keep its overnight lending rate at 0.25% through 2021.
“We believe that the end result of this deep downturn will, in fact, be even milder inflation than the low-inflation world that prevailed pre-virus,” states a report from Douglas Porter and Sal Guatieri, econo- mists with Toronto-based Bank of Montreal, that was published inMay.
On July 1, 2020, the prescribed rate, announced quarterly by the Canada Revenue Agency (CRA), will drop to 1% from 2%, mak- ing prescribed-rate loan strat- egies even more attractive, says Michelle Connolly, director of tax and estate planning at Sun Life Financial Inc. in Toronto: “Once you’ve negotiated a 1% prescribed-rate loan, [that rate is set] for the duration of the loan. Over 20 or 30 years, the overall tax savings on that investment income [can be significant].”
In this challenging economic environment, high net-worth cli- ents are drawn to tax strategies, such as income splitting, that can lower a family’s overall tax bill. “[They know], after this pan- demic is over, that somebody is going to have to pay to fill in the deficit, and that’s going to be tax- payers,” Bezaire says.
Generally, the Income Tax Act (ITA) frowns upon income split- ting between spouses: income or gains earned on money trans- ferred to a spouse is attributed to the spouse who originally trans- ferred the money. However, the ITA permits a person to lend money, at the prescribed rate of interest or higher, to their spouse without triggering the attribu- tion rules. Thus, a high-earning spouse can shift the taxation of investment income and gains to a spouse in a lower tax bracket by using a prescribed-rate loan. The lender is required to claim only the interest on the loan as income.
Connolly suggests that a pre- scribed-rate loan strategy can be especially powerful when com- bined with tax-loss harvesting. For example, a high-income person could sell losing invest- ments this year, then apply those capital losses against any cap- ital gains from 2020 or, if there weren’t any gains in the year, apply net capital losses against net capital gains in any of the three preceding tax years (when equities market returns were probably higher) or carry losses forward to future years.
“Any taxes paid on those gains [from the three preceding years] is refunded,” Connolly says.
Then, the higher-income spouse would make a pre- scribed-rate loan to the low- er-income spouse, who would purchase investments with the money. Any gains would be real- ized by the lower-income spouse and taxed at their lower rates. Careful planning is required: if the lower-income spouse pur- chases the same investments as were held by the high-earning spouse, that action may trigger the superficial loss rules in the ITA, which would lead to capital losses being denied.
A prescribed-rate loan can be set up to move investments in kind rather than cash between spouses, Bezaire says. If an investment is in a loss position, but the transferring spouse has no capital gains against which to apply those losses, lending the investment itself rather than selling it first — particularly if the borrowing spouse does have capital gains — may make sense. After holding the investment for
at least 30 days, the borrowing spouse can sell it and realize the capital loss.
“The best part is no money has to change hands,” says Bezaire, who cautions that in-kind pre- scribed-rate loans require care- ful tax planning.
Lending money at the pre- scribed rate to a discretionary family trust also is possible. Income and gains earned on the borrowed money can then be used to split income with family members without triggering attribution rules. For people who own significant non-registered assets, prescribed-rate loans to a family trust “could result in thousands or even tens of thou- sands of dollars of potential tax savings,” Heath says.
Clients who may already have set up a prescribed-rate loan strategy when the prescribed rate was at 2% or higher may be looking to switch their current loan to one at 1% beginning July 1, Bezaire says.
To do so, these clients will have to pay off the original loan, then set up a new one at the lower rate. “If you just move [the loan’s interest rate] down to 1%, the CRA will say, ‘No, it wasn’t a bona fide spousal loan’,” Bezaire says.
Clients who need insurance as part of their broader financial planning may consider various leveraged insurance strategies, Heath says: “[There are] different ways that you can borrow to fund insurance policies and different ways you can borrow against insurance policies.”
Clients also may consider leveraged investing, particu- larly if the yield on an invest- ment purchased exceeds the rate of interest on the margin loan or if there are significant gains expected. The interest costs associated with the margin loan can be deducted against the investment income generated for tax purposes, Bezaire says, and “you can get your investment at a lower cost as well” because equi- ties’ prices have dropped.
Margin investing, however, is appropriate only for a small min- ority of clients who have high risk tolerance, and for whom such a strategy makes sense in terms of both tax and investment planning.
“I usually don’t recommend [margin investing] unless there’s a super-good tax reason,” says Julia Chung, CEO of Spring Financial Planning in Vancouver. She points out that while leverage can magnify gains, “it also does the same thing to your losses.”
Heath says he prefers lever- age when investing in real estate more than for investing in secur- ities — not because real estate is necessarily a better investment, but because it’s more difficult for clients “to panic and hit the sell button” on real estate holdings relative to a portfolio of stocks. “It’s knee-jerk reactions that can cause a leveraged investor to get in trouble,” Heath says.
Chung says that since interest rates dropped earlier this year, she’s received calls from clients asking whether it’s a good time to switch from variable-rate mort- gages on their homes or other real estate investments to locked-in rates. “It depends,” Chung says, “but we have to explain to them that locked-in rates aren’t the same as variable rates.”
Clients who, against advice, chose not to build an emergency fund during the bull market, Chung says, may now be regret- ting that lack of cushion. She advises such clients to secure
a line of credit rather than sell investments at a deep loss. “Opening a line of credit that [the client] wouldn’t touch, but is available, is sometimes a good safety measure,” Chung says.
Conservative clients, on the other hand, may be sitting on enough cash for an adequate safety cushion but feel para- lyzed regarding how and when to invest — stuck between the pal- try rates offered by guaranteed investments and the volatility of the market. Diversification, as always, is a cautious investor’s best friend.
“Low rates of return [on guaranteed investments] in a low-inflation environment are just something that people need to accept,” Heath says. “To the extent that someone can take on stock market risk or just invest in riskier asset classes than sav- ings accounts and GICs, [that client] should consider it. With a five-plus year time horizon, a balanced portfolio should gen- erate a higher rate of return than a savings account or GICs.”
Says Chung: “I think invest- ments should be super-boring. I have no idea if this is the right time [to invest] and neither does anyone else — and they never have.” IE
In July, the prescribed rate, announced quarterly by the Canada Revenue Agency, will drop to 1% from 2%
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