Children and grandchildren often want some financial help, and parents and grandparents frequently are glad to provide it. Too often, everyone involved considers the help to be a private arrangement. The IRS, however, has an interest in the transactions.
When you don’t review the tax rules and structure the arrangements the right way, you might be surprised by a tax bill and penalties down the road. Before considering the IRS’s interests, consider the rest of the family.
Many family loans are made with the expectation that they won’t be repaid unless the financial condition of the lender changes and they need the money back. That usually means the loan will be forgiven when the lending parent or grandparent passes away.
If that describes your situation, you need to have this memorialized in your estate plan. The standard practice is to state the details of the loan and provide that it is forgiven on the lender’s death. When the lender wants all family members to be treated equally, the will also should state that the amount inherited by the debtor is reduced by the amount of the forgiven loan.
You don’t have to take that last step. Not everyone wants to treat family members equally. They reason that one child needs help more than the others, and they want to provide that extra help. So, they don’t want the forgiven loan to reduce the borrower’s share of the final estate. Now, let’s look at the tax rules. Many family loans don’t carry an interest rate and don’t require fixed payments. They essentially are demand notes. Payment isn’t due until the lender demands it.
That runs afoul of the tax rules. In a family loan, when there is no interest rate or a rate below the IRS-determined minimum rate, the interest that isn’t charged is assumed to be income to the parent from the child. In other words, there is imputed income or phantom income. The parent is to report interest at the IRS-determined minimum rate as gross income, though no cash is received.
The borrower might be able to deduct the same amount if they qualify for the mortgage interest deduction. In addition, the lending parent or grandparent is assumed to make a gift of the same amount to the borrowing child or grandchild. In most cases, the annual gift tax exclusion is more than sufficient to prevent the gift from having any tax consequences. In 2019, a person can make gifts up to $15,000 per person with no gift tax consequences under the annual gift tax exclusion. A married couple can give up to $30,000 jointly.
To avoid these tax consequences, there should be a written loan agreement that states interest will be charged that is at least the minimum interest rate determined by the IRS for the month the agreement was signed. You can find the minimum rate for the month by searching the internet for “applicable federal rate” for the month the loan agreement was made.
The rate you use will depend on whether the loan is short-term, mid-term, or long-term and on whether interest compounds monthly, quarterly, semiannually or annually. It is a good idea for the borrower to at least make interest payments on a regular basis.
Otherwise, the IRS could argue that there wasn’t a real loan and the entire transaction was a gift. There are two important exceptions to the imputed interest rules.
A loan of $10,000 or less is exempt. Make a relatively small loan and the IRS doesn’t want to bother with it. The second exception applies to loans of $100,000 or less. The imputed income rules apply, but the lending parent or grandparent can report imputed interest at the lower of the applicable federal rate or the child’s net investment income for the year. If the child doesn’t have much investment income, the exception can significantly reduce the amount of imputed income that’s reported.
The applicable federal rate is based on the U.S. Treasury’s borrowing rate for the month. That means it’s a low rate and is likely to be a lower rate than the child or grandchild could obtain from an independent lender. To avoid tax problems with a loan to a family member, first be sure there’s a written loan agreement. The agreement should state the amount of the loan, the interest rate and the repayment terms.
Simple loan agreement forms can be found on the internet. The interest rate should be at least the applicable federal rate for the month the loan is made. If the loan calls for regular payment of interest, or interest and principal, those payments should be made and should be documented. The more you make the transaction look like a real loan, the less likely it is the IRS will try to tax it as something else, such as a gift.
A written loan agreement also can prevent any misunderstandings between the borrower and your estate or other family members after you’re gone. As mentioned earlier, decide how you want any unpaid loans handled in your estate and have that recorded in your will.
Suppose Hi Profits, son of Max and Rosie Profits, wants to purchase a home and needs help with the down payment. Max and Rosie lend $100,000 to Hi. They charge 3.22% interest on the loan, which was the applicable federal rate in July 2019 for a long-term loan on which the interest is compounded semiannually.
If Hi doesn’t make interest payments, Max and Rosie will have an imputed income of $3,220 each year that must be included in their gross income. In addition, they will be treated as making a gift to Hi of $3,220 each year.
As long as they don’t make other gifts to Hi that put them over the annual gift tax exclusion amount ($30,000 on joint gifts by a married couple), there won’t be any gift tax consequences. Hi can have the loan recorded as a second mortgage against the property.
That might enable him to deduct the imputed interest on his income tax return, though he made no cash payments. Max and Rosie have two costs to the loan.
The first cost is the investment income they could have earned on the $100,000. The other cost is the income taxes they’ll owe on the imputed interest income. That will depend on their income tax bracket. Family loans are in wide use. Be sure you take the extra steps needed to avoid problems with the IRS.