Gregory S. DuPont
Keeping Taxes Low When Making Loans to Family Members
While small interest-free loans may be common in your family, you should be aware that all larger transfers of money between adult family members can have tax consequences. Yet, when structured properly, intra-family loans can serve as a means of passing on wealth to the next generation, while keeping interest payments within the family and minimizing income taxes.
There are many reasons why you may wish to loan larger sums of money to adult children or other family members, including providing them with capital to start a business, buy a home, make an investment, or pay off personal debts. But if the amount loaned is substantial, generally more than $10,000, consider drafting an enforceable promissory note stating the terms of the loan. This document usually includes information about the loan amount, repayment dates, the rate of interest, and any collateral or security provided by the borrower. In the absence of a valid note, the Internal Revenue Service (IRS) could classify the transaction as a gift that may be taxed accordingly.
While it is not always necessary to seek legal help in drafting a promissory note between family members, you may want to consider securing the note with the property if the loan is being used toward the purchase of a home. Failure to report a loan on a mortgage application could have legal consequences. Therefore, it makes sense to consult a lawyer when drafting these types of loan agreements. While the IRS usually ignores intra-family loans of under $10,000, special rules apply if the funds are used to purchase income-producing assets.
If you are the lender, you are required to declare the interest income on loans exceeding $10,000 that are not paid back within the year on your income tax return. If you fail to charge interest or do not charge interest above a certain rate, the IRS could classify the transaction as a taxable gift or tax you on the interest you would have received from the loan based on what the IRS considers to be a minimum interest rate. To provide guidance to lenders and borrowers, the IRS has established minimum interest rates for loans between family members. These so-called Applicable Federal Rates (AFRs) vary according to the length of the loan and the current yield on Treasury securities. AFRs are updated monthly on the IRS website.
If the loan amount is $100,000 or less and the borrower does not have net investment income exceeding $1,000 for the year, the transaction is generally exempt from these so-called “imputed interest” rules. But if, for example, the borrower has investment earnings amounting to $1,500, while the imputed interest on the loan based on the AFR is $2,000, the lender will only be required to report $1,500, or the total amount of the borrower’s investment earnings for the year, as interest income. The lender may also choose to forgive a portion of the loan each year up to the amount of the gift tax exclusion, which is $14,000 per gift made by an individual and $28,000 per gift made jointly by husband and wife in 2015.
If your relative fails to repay the loan, you may be able to write off the default as a short-term capital loss on your taxes. To claim this deduction, you must demonstrate that you have made a written request for repayment from your family member. Keep in mind, however, that the IRS may then assume that the debt has been forgiven and attempt to collect additional taxes from your relative.
From the perspective of the borrower, the tax implications of a loan from a family member will vary according to the purpose of the loan. The interest paid on a loan used to cover personal debts is not deductible, but interest payments on a loan used for business purposes may be classified as a deductible business expense. Provided the property is secured by a note through a mortgage or trust deed, the borrower may be able to deduct interest payments on the loan as mortgage interest. If the money borrowed is invested, the interest will be subject to investment interest rules.
Whatever the nature of your personal relationship with a family member to whom you are lending money, it is important to remember that proper documentation and careful consideration of the tax and legal consequences of the loan can help to protect the interests of both parties and preserve good will between you. Before lending significant sums, always consult your attorney and tax professional.