Loans To Relatives
PUT ALL FAMILY LOANS IN WRITING
Documentation is critical on any family loan. If the loan goes bad, you’ll want to claim a tax deduction. But, without proper paper work, an IRS auditor will say the transaction was a gift, which means no deduction for you and a possible problem with a missing gift-tax return as well.
You need evidence that the deal was, in fact, intended as a loan. That means a written promissory note, which includes the following details:
- The interest rate
- The dates and amounts for interest and principal payments
- Security or collateral for the loan
Your tax records also should include evidence that the borrower was solvent and capable of repaying the loan at the time you made it. If you maintain a personal balance sheet, be sure it shows the loan as a receivable on the asset side of the ledger.
If the borrower uses the loan proceeds to buy a home, the loan must be secured by the residence for the borrower to deduct the interest.
When you charge an adequate interest rate on family loans, things are very simple, and you can ignore much of what follows. In January 2003, the minimum IRS-approved rates for loans with annual compounding were:
- 1.81% for “short-term” loans of up to 3 years
- 3.43% for “mid-term” loans of 3 to 9 years
- 4.90% for “long-term” loans of 9 years and more
These so-called applicable federal rates, or AFRs, change monthly.
If you want to charge the AFR for a family loan, you’d charge the rate for the month that the loan is made. Monthly AFRs are published in Internal Revenue Bulletins, which you can access at the IRS Web Site, www.irs.gov.
Say you want to lend your adult son $25,000 to help him buy his first home. If you set up a 3 year loan, you can charge as little as 1.81%. For a 30 year loan, you can charge as little as 4.90%.
Either way, it’s a great low-interest deal for your son. You will be taxed on the interest you collect.
AVOID TAX ON INTEREST-FREE LOANS
Although you can charge low rates on family loans, you may want to make totally interest-free loans. If so, you’ll fall under the so-called “imputed interest” rules, which could lead to unexpected and messy tax consequences for you, the lender.
When you make an interest-free loan, the IRS sees it as an imputed (imaginary) gift to the borrower equal to the amount of AFR interest that you could have charged but didn’t. The borrower is then considered to repay these phantom dollars to you as imputed interest, which you must include in your taxable income.
In other words, you have to pay income tax on interest you never actually received. Also, if your imputed gift exceeds $11,000, it will reduce your $1 million federal gift and estate – tax exemptions.
STRATEGY 1: TAKE ADVANTAGE OF THE $10,000 LOOPHOLE
You can completely avoid the imputed interest rules as long as any loans between you and the borrower add up to $10,000 or less. This includes all outstanding loans between you and that person, whether you charge adequate interest or not.
Example Say you decide to make a $10,000 interest-free loan to your daughter to help her start a small business. This arrangement has no federal tax consequences for either of you, as long as you have no other outstanding loans to her.
STRATEGY 2: TAKE ADVANTAGE OF THE $100,000 LOOPHOLE
Another favorable loophole applies when the balance of all outstanding loans between you and the borrower is between $10,001 and $100,000. However, the complicated imputed interest rules come into play here.
For income tax purposes, you (the lender) can ignore the imputed interest rules, as long as the borrower’s net investment income (from dividends, interest, etc.) for the year is less than $1,000. If that figure exceeds $1,000, the taxable amount is limited to the actual amount of the borrower’s investment income or the amount of imputed interest, whichever is less.
In most cases, the borrower has little or no net investment income. So you probably won’t have to report any taxable income from imputed interest.
To navigate this loophole, you must obtain an annual signed statement from the borrower disclosing the amount of his or her net investment income for the year. Keep it with your tax records.
DRAFT A “DEMAND” LOAN, NOT “TERM“ LOAN
With the income-tax rules covered, here’s the next question: What about gift taxes? To avoid gift-tax problems under the $100,000 loophole, make sure your interest-free loan is a “demand loan” as opposed to a “term loan.”
With a demand loan, you can require full repayment at any time, even though you may have an informal understanding with the borrower that he or she will follow a set payment schedule. With an interest-free demand loan, the gift of imputed interest is calculated annually using the short-term AFR.
In contrast, if you make an interest-free term loan (say one calling for repayment over 10 years) you’re treated as making an immediate imputed gift to the borrower equal to five years’ worth of imputed interest. This can result in an imputed gift in the year you make the loan that exceeds your $11,000 federal gift-tax exclusion.
The excess would whittle down your $1 million federal gift and estate tax exclusions. Plus you’ll have to file a gift tax return (even though you won’t actually owe any tax).