Loaning Money to Your Adult Children
You may lend money to your child to help with the purchase of a major personal item. A common example is a loan to help with the purchase of a child’s first home. Generally, this doesn’t create tax problems if they are made for adult children. (A loan to a child under 18 triggers the “attribution rules”.)
If the loan is interest-bearing, you must declare it on your tax return. The child cannot deduct the interest on a loan used for personal purposes. However, if they use the loan for investment purposes − say, to buy a rental property instead of a personal residence − they can deduct the interest they pay you.
If the loan is interest-free and used for personal purposes by your child, this also poses no tax problems. However, if the interest-free loan is used by your child for investment purposes, there is a special attribution rule in the Income Tax Act that may apply.
This attribution rule has the effect of causing the resulting investment income to be included in your income rather than that of your child. This rule might apply if you are in a high tax bracket and your child is in a low tax bracket and one of the main reasons for the loan was to shift investment income into your child’s hands to reduce overall tax. If this was the case, the investment income may be attributed to you and included in your income. The Canada Revenue Agency does not often apply this rule, but it is an important rule to consider and to ensure that income splitting is not documented as a main purpose for the loan. There should be other genuine reasons for the loan and income splitting should not be one of them. Note that this attribution rule does not apply to capital gains if your child sells the investment. It can only apply to income from property – which includes interest income, dividends, and rental income.
Avoid Attribution Rule
One way to avoid the attribution rule is to charge interest at the “prescribed rate” under the Income Tax Act at the time the loan is granted. This rate is typically low, and for the first quarter of 2022 is currently set at 1%. These loans should be properly documented.
Where the loan is used for the child’s personal purposes, if you subsequently forgive the loan, there are no income tax consequences for the child. Forgiveness is basically treated like a gift.
If the loan is used by the child for investment or business purposes, there can be adverse tax consequences for the child if you forgive the loan. However, there is an exception if the loan to your child remains outstanding upon your death, and it is settled or forgiven under the terms of your will.
In this case, there are no income tax issues even if the loan was used for income-earning purposes.