Tax Tips
Loans For Family Members - January 2005
Richard Scrivanich - Partner
Structuring Loans to Family Members
In today’s challenging economy, more and more family members are seeking financial help in the form of loans from parents and other relatives. While there is nothing inherently wrong with helping a family member, there are important practical and tax matters that you should consider before making an intrafamily loan.
Treat the decision to lend seriously
Give careful thought to whether you honestly want to loan money to your son, daughter, or other family member. You’ll also want to consider how much you can comfortably give. Don’t put your own financial future at risk by lending money you can’t afford to lose. Saying “no” may not be easy, but doing so now can help avoid a more difficult situation down the road.
Put it in writing
Should you decide to lend money to a family member, make the deal as businesslike as possible. While it may seem overly formal to document a loan to a family member, without one, the Internal Revenue Service (IRS) could argue that there was no loan at all — that the money you gave was really a gift. What’s more, should the borrower be unable to repay all or some of the loan and you want to write it off as a nonbusiness bad debt, documentation showing that the loan actually existed could be critical.
Set an interest rate
Many families choose to make no-interest or below-market-interest loans to family members. According to the Internal Revenue Code, a below-market loan is one that has an interest rate lower than the applicable federal rates (AFR) established by the IRS as the minimum for loans between family members. AFR rates are based on the type and term of the loan and are set monthly by the federal government.
For a demand loan (a loan payable in full at any time on the lender’s demand), if the lender does not charge interest at least equal to the AFR, he or she is considered to have received “imputed” interest. This means that the lender owes tax on the amount he or she would have received if the AFR had been used. And, for gift tax purposes, the lender is treated as if he or she gave the borrower a taxable gift of the imputed interest amount each year the loan is in force.
There are, however, two important exceptions to the imputed interest rules. The first exception is known as the $10,000 gift loan exception. This means that the below-market imputed interest rules do not apply to individual loans with an aggregate outstanding amount of not over $10,000 on any given day. However, this exception does not apply if the loan proceeds are used to purchase income-producing assets.
A second exception protects even larger low- or no-interest loans. For below-market gift loans up to $100,000 between individuals, the amount of interest added to the lender’s taxable income is limited to the borrower’s net investment income. In cases where the borrower’s net investment income is less than $1,000, the lender will not be required to include any imputed interest from the loan in his or her taxable income.
For example, if you gave your child an interest-free loan to buy a home or start a business, you wouldn’t pay any tax on imputed interest as long as he or she doesn’t earn net investment income over $1,000. If your child’s investment income exceeds $1,000, the imputed interest income rules apply. For gift tax purposes, foreign interest is treated as a taxable gift.
Tread carefully
Clearly, loaning money to family members is not something you should do casually. It can damage personal relationships and cause income, gift, and estate tax planning problems. Given the complexity of the imputed interest rules and the related exceptions, it’s wise to seek professional advice in structuring loans to family members.
If you have any questions relating to structuring loans to family members or any other tax matter, please give me a call at (562) 698-9891.
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