By: Randall A. Denha, Esq.
It’s often said that there is no such thing as a free lunch. This couldn’t be more evident than in the tax law and especially when a family member loans money to another member of the family. Suffice it to say, the IRS isn’t giving anything away for free even though you might have thought you had. When a person makes a loan to a family member, friend or relative at less than the market rate of interest, there may be adverse tax consequences in the areas of income tax and gift tax.
As a general rule, the IRS presumes that intra-family loans are, from the beginning, actually disguised gifts. As such, the burden falls on the lender to convince the agency otherwise. Even though the loan is interest free or carries a very low rate of interest, you may incur imputed interest income as a result of making the loan. What is imputed interest? It is interest considered by the IRS to have been received, even if no interest was actually paid.
Imputed interest applies to below-market loans. A below market loan is one that is interest-free or one that carries stated interest below the applicable federal rate (AFR). The AFR is the minimum rate you can charge without creating tax side effects. Every month the IRS publishes AFR’s. The AFR for a loan is the interest rate for loans of that duration in the month the loan is made. For example, suppose a $300,000 interest-only demand loan is made in September 2011. The borrowers will be making payments of interest only, no amortization of the loan principal (although they may make any principal payments they wish). A demand loan, which means that it can be called as due any time by the lender, is a short-term obligation so it can use the short-term AFR. The annual interest on a $300,000 loan at the rate of 0.16% is $480, or $40 per month.
When the loan is a demand loan, the applicable Federal rate is the applicable Federal short-term rate in effect for the period for which the amount of forgone interest is being determined, compounded semi-annually. If a demand note is outstanding for an entire calendar year, the government’s blended rate must be used. In July of each year, the government publishes the blended rate for the current year. For example, the blended rate published in October 2011 is 0.32%. Let’s say you made a loan today. It was a demand loan for $300,000; the AFR blended rate is 0.32%. If you charge at least that much interest, and the blended rate for subsequent years, you don’t have to worry about the rest of this explanation. If you charge no interest, or interest less than the 0.32% then you are treated as if you made a gift to the borrower. This gift is the difference between the AFR and the interest you actually charged, if any. The borrower is then deemed to have paid that amount back to you as interest (this is the imputed interest). You must report the imputed interest as income on your income tax returns. The borrower may get a deduction depending on what the funds were used for.
If the loan is under $10,000, there is no problem. You can ignore the imputed gift and the imputed interest if the aggregate amount of loans between you and the individual is less than $10,000. Note that all loans outstanding between you and the individual when added up, must be less than $10,000. If the loan is over $10,000 but less than $100,000, there is another exception to the application of the imputed interest rule which may save you. Taxable imputed interest income to you is zero as long as the borrower’s net investment income for the year is no more than $1,000. That takes care of the income tax.
Now for the gift tax. Unfortunately, there is no similar $100,000 exception for the gift tax. The best way to structure the loan for gift tax purposes is as a “demand loan,” that is, a note that can be called for full payment by the lender at any time. With a demand loan, the imputed gift amount is computed every year and will fluctuate with the annual blended AFRs published each July. The annual imputed gift will be well under the $13,000 annual exclusion for gifts until the loan exceeds $2 million with the current rates. If the loan, rather than being a demand loan, is a term loan, the gift tax results are less favorable. When the loan is made you are treated as making an immediate gift of the whole terms’ worth of below market interest. This will likely exceed the $13,000 annual exclusion and require filing a gift tax return and use of part of your unified credit or actual payment of gift tax if your credit has already been used.
The best thing is to avoid all this complexity. If you make a loan of more than $10,000 to a friend or relative, charge the applicable federal rate of interest. And get it in writing! If you make a below market loan to a family member, and if the loan is not repaid, the IRS may consider it a gift for tax purposes whether you intended the money to be a gift or not. If this is the case, you may be required to file a federal gift tax return, depending upon the initial amount; and you will not be able to deduct it as a non-business bad debt. If the loan is used by the family member to buy a home, make sure the note is secured by a mortgage. If it isn’t, the borrower will not be able to deduct the interest that they do pay to you.
It is always possible to forgive payments on loans, converting a debt obligation to a gift. Since the annual exclusion is $13,000, you can forgive $13,000 of the debt obligation annually with no gift tax consequences. If the loan is from a married couple to a married couple, maybe Mom and Dad to Daughter and Son-in-law, up to $52,000 (4 x $13,000) in interest and principal payments could be forgiven each year with no gift tax consequences. Mom and Dad have interest income to report on their 1040. Son and Daughter-in-law are treated as having paid interest.