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, the California Society of CPAs (www.calcpa.org) points out that there are important practical and tax matters that should be considered 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 or below-market interest loans to family members. According to the Internal Revenue Code, a below-market loan 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. They can be found in the first Internal Revenue Bulletin published for each month and are located under “Tax Information for You” on the IRS Web site at www.irs.gov.
Be Aware Of Rules Concerning Imputed Interest
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 applicable AFR, he or she is considered to have “imputed” interest and is taxed on the difference between the federal rate and the rate actually charged. In other words, the IRS assumes that the borrower paid interest to the lender and the lender may be required to pay income taxes on the amount he or she should have received. For gift tax purposes, the lender is treated as if he gave the borrower an annual taxable gift of the imputed interest amount.
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 loans up to $100,000 to individuals to buy a home or start a business, 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. If you charge a low interest rate, rather than no interest, the imputed interest is based on the difference between what you actually charge and the amount due, using the applicable federal rate.
Clearly, loaning money to family members is not something that should be done casually. It can damage personal relationships and cause income tax and estate planning problems. Given the complexity of the imputed interest rules and the related exceptions, it’s wise to work with a CPA in structuring loans to family members.