One of the first personal finance lessons young people learn is that a bank is a place that will lend you money if you can prove that you don’t need the funds. Which is why the bank of mom and dad has become a popular place for younger Canadians to find financial help. Last week I shared a primer on how to lend money to your kids. Today, I want to finish that conversation with some tips and traps to think about when it comes to kids and loans.
A primer on how to lend money to your kids properly
Loans to save tax
Lending money to your children or grandchildren can be a form of an “estate freeze,” which can save you tax at the time of your death. An estate freeze is the idea of passing the future growth of certain assets to someone else – most commonly your kids – so that you won’t pay tax on that growth. By lending money to an adult child, any future growth of those funds will generally be taxed in the hands of your child, not your hands (there can be an exception if the taxman concludes that one of the main reasons for making the loan was to reduce your own taxes; but it’s rare to see this rule applied). Further, you’ll avoid probate fees on that growth if you live in a province or territory that levies that type of tax when you die. You can always forgive the loan upon your death without any tax consequences.
Loans accompanying a sale
If you want to transfer an appreciated asset to your kids during your lifetime (a cottage is a good example) there will generally be tax to pay on the capital gain in the year of the transfer. You can spread this tax liability over a period as long as five years by selling (not gifting) the asset at fair market value to your child and taking back a loan as consideration for all or part of the sale price. This way, your child doesn’t have to come up with cash today – or ever – to pay you, if that’s your preference. And you can forgive the loan upon your death with no tax issues.
Loans that earn second generation income
If you lend money to a minor child, or a trust for them, and the loan proceeds are used to earn income from property (including interest, dividends, rents or royalties), the income will be attributed back to you and taxed in your hands. But any second generation income – that is, income on the income – will not be attributed back to you. So, consider lending money and leave that loan outstanding until the second generation accumulates to a meaningful amount over several years. Move that second generation income to a separate account each year and watch it take on a life of its own.
Loans by U.S. persons
If you happen to be a U.S. citizen, resident or green card holder then you have to think about U.S. gift taxes and estate tax laws. If you make a gift to your children you could be subject to U.S. gift taxes unless the gifts are below the annual gift tax exclusion (currently US$18,000 per beneficiary per year) or you utilize all or part of your lifetime estate and gift tax exemption (which is US$13.61-million for 2024 – a high figure for most people – but is scheduled to be reduced to about half of this amount on Jan. 1, 2026, unless the U.S. Congress acts to extend the sunset date for this exemption). A loan to your children can avoid a gift tax problem. Make sure you visit a tax pro if you’re a U.S. person.
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 them), the loan will be treated as though it was made directly by you. Further, if your minor child (or a trust for them) 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.
Loan repayments
What if you lend money to your child and they repay you (as unlikely as that might be)? There are no negative tax consequences. But if your child makes a gift to you over and above the principal amount of the loan, perhaps to compensate you for using your money, be aware that the taxman will generally hold the view that the gift was an amount received by you “on account of, or in lieu of, or in satisfaction of interest.” In this case, you could end up paying tax on that “gift” as though it was interest income.
Tim Cestnick, FCPA, FCA, CPA(IL), CFP, TEP, is an author, and co-founder and CEO of Our Family Office Inc. He can be reached at tim@ourfamilyoffice.ca.
