Tax Tips
Smart Handling of Intra-Family Loans - May 2008
Richard Scrivanich - Partner
Even though the housing market has cooled off, home prices are still high in many areas of the country. To help your son or daughter buy a starter home, you might want to make a loan. If you do, be careful. You may face surprising and painful tax consequences if you charge no interest or below-market rate.
Imputed interest
Say your son wants to buy a home. You loan him $300,000, payable in 9 years, and you don't charge him any interest.
The IRS will impute interest on such loans at an applicable federal rate (AFR). AFRs are published every month at www.irs.gov. Currently, the AFR on loans from 3 to 9 years is about 5% (see table below). In the example above, therefore, the imputed interest would be around $15,000 (5% of $300,000).
Tax treatment
In this scenario you would have to recognize $15,000 in interest income each year. You would owe income tax on that $15,000 even though you didn't collect it.
Moreover, the IRS would say that you had made your son a $15,000 gift for each year of the loan. You would have to file a gift tax return. (You wouldn't have to pay gift tax unless you had used up your $1 million life time gift tax exclusion, but your estate tax exemption would be reduced).
At the same time, your son might be able to take a $15,000 deduction for the imputed interest on a loan secured by his residence.
Below-market loans
What if the loan called for a 2% interest rate, which your son paid? This rate would be 3% below the 5% AFR. In that case, the imputed interest on the loan would be 3%, subject to the tax consequences described above. In addition, the 2% of actual interest would be taxable to you and might be deductible for your son.
The $100,000 exception
Loans up to $100,000 also won't generate imputed interest if the borrower's net investment income is no more than $1,000 in given year.
Suppose you lend your daughter $100,000 to help her buy a house. If her investment income this year is $500, the IRS will not impute any income for the interest. If her net investment income next year is $1,100, some or all of the interest will be imputed income. The amount of imputed income to you the lender would be her net investment income or the amount derived from the AFR rate, whichever is lower. Say the AFR rate is 5% which would be $5,000 on a $100,000 loan. Your daughter's $1,100 in net investment income would be lower than $5,000, so that year's imputed interest would be $1,100.
Keep in mind that the $10,000 and $100,000 exceptions apply only to income tax. Such interest-free loans or below-market loans still will have gift tax consequences.
Charge at least the AFR
In order to avoid income and gift tax problems, for all types of intra-family loans the best tax strategy is to charge a rate that's at least as high as the AFR. All parties should sign a written agreement spelling out the terms of the loan, and then follow its terms. If there is no formal loan agreement and the borrower pays no interest, the IRS may re-cast the transaction as a gift rather than a loan. Then the entire amount could be treated as a gift, triggering a gift tax.
If you have any questions regarding the above discussed topic, or any other tax matter, please feel free to give me a call at (562) 698-9891.
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