Gregory S. DuPont
Loaning Money to Your Children
What to Watch For
Even though your children have grown up and left home, they may still require financial assistance. Although they earn money on their own, the cost of living and the acquisition of such things as a home can be beyond their means, and you may want to provide a lending hand. While large loans from parents to offspring are quite common, it is important to pay attention to the tax rules that apply to the transaction.
The best loan structure will provide your child with a tax deduction for the interest he or she pays to you. To accomplish this, you must prove to the Internal Revenue Service (IRS) that the loan is a mortgage secured by your child's principal residence. A mortgage agreement drawn by an attorney can give you a lien on your child's residence and ensure the tax deductibility of the interest payments.
The tax rules are straightforward when you use a fair market rate. You pay income tax on the amount of interest you receive and your child deducts that amount from his income. The IRS determines fair market interest rates monthly.
If you charge your child a below market rate or no interest at all, however, the tax accounting becomes more complex. In fact, you may pay tax on more interest than you actually receive and a gift tax as well. On the other hand, your child could deduct more than he or she actually pays you.
Here's a hypothetical example of how it works: Suppose you lend your child $150,000 at 5 percent when the market rate is 9 percent. Your child pays you $7,500 a year in interest instead of a fair market amount of $13,500. Under the IRS rules, you have to pay income tax on the full $13,500 and your child can deduct all $13,500, even though he or she didn't pay all of it. The IRS then considers the $6,000 difference as a gift from you to your child, subject to gift tax rules. As long as that amount, combined with any other gifts to your child that year, remains below the $10,000 annual gift tax exclusion ($20,000 for joint husband and wife gifts), you don't have to pay gift taxes. In addition, an individual has the unified credit to offset any tax due.
Before making a loan to any of your children, establish the required pay-back interest rate and schedule so that the benefits you provide your child do not impact your personal financial plan negatively.