Over the past several years, there has been a significant increase in the amount of intra-family loans. While these can be great tools, it is very important to consider the tax issues related to such a transaction. The IRS may see the loan as a gift, which could then be subject to unexpected tax consequences.
Types of loans that can be subject to restructuring by the IRS
- Gift Loan – any below-market-rate loan in which the forgone interest is in the nature of a gift
- Demand Loan – any loan that is payable in full at any time on the demand of the lender. This also includes any loan with an indefinite maturity.
- Term Loan – any loan that is payable on a specific date
The IRS may treat the loan as a gift, despite the fact that a note was given at the time of transfer, if the IRS deems the transfer is not genuine and was not made in good faith.
Example: A $100,000 note between a father and son, which the father does not expect to ever be repaid. Even if the note is properly documented, the IRS will deem the transfer a gift. A gift tax return must be filed, and tax will be calculated if it exceeds the $15,000 per recipient gift tax exemption ($30,000 if gift splitting with spouse).
If the lifetime exemption amount has not been fully utilized, then no money actually has to be paid to the government, as it will merely reduce the "free" amount available for future gifts and for transfers to beneficiaries at death.
Prevent IRS Loan Restructuring and an Unexpected Tax Bill
- Be sure to get it in writing – sign a promissory note
- Establish a fixed repayment schedule for interest and/or principal
- Set the rate at or above the Applicable Federal Rate (AFR) in effect when the loan is originated
- Secure or collateralize the debt (mortgage)
- Maintain records that reflect a true loan transaction, including timely payments
- Do not have a prearranged schedule to forgive the loan. Forgiveness is ok as long as it is not expected or pre-arranged.
The IRS will deem any forgone interest on an interest-free loan between family members as a gift for federal tax purposes, regardless of how the loans are structured or documented. Interest will be imputed if it is interest-free or at a rate below the AFR. The interest forgone, which is the difference between the actual interest charged and the federal AFR rate, is deemed to have been transferred from the lender to the borrower as a gift subject to gift taxes, and then the borrower to the lender as interest income, which must then be recognized on the lender's individual and state tax returns.
There are some exceptions when the AFR is not required to be charged on a loan. First, if all loans between those two individuals do not exceed $10,000, and the loan is not directly attributable to the purchase or carrying of an income-producing asset, then the interest rate can be below market and no imputed interest will be required to be calculated. If at any time the aggregate loans to that individual exceed $10,000, then this exception will not apply, and the loan will still be subject to gift and income taxes regardless of the remaining principal amount.
The second exception is if the aggregate outstanding amount of gift loans between individuals does not exceed $100,000, the imputed interest amount for income tax purposes is limited to the borrower’s net investment income for the year. However, there is a de minimis rule: if the borrower had less than $1,000 of net investment income for the year, the investment income for this exception is deemed to be zero.
Example: Assume dad makes an interest-free $75,000 loan to his son so that he may start a business. Dad forgoes the imputed interest each year ($1,100 for example), which is treated as a gift. No gift tax will be due since it is below the annual $15,000 exclusion, and dad owes no tax on the forgone interest if the son has $1,000 or less of net investment income.
After taking everything into consideration, loaning money to family members is not something to take casually. Given the complexity of the IRS rules on restructuring and imputed interest, it's always best to consult with your tax advisor before making a personal loan. Please call us if you would like to discuss an intra-family or below-market-rate loan.
LBMC tax tips are provided as an informational and educational service for clients and friends of the firm. The communication is high-level and should not be considered as legal or tax advice to take any specific action. Individuals should consult with their personal tax or legal advisors before making any tax or legal-related decisions. In addition, the information and data presented are based on sources believed to be reliable, but we do not guarantee their accuracy or completeness. The information is current as of the date indicated and is subject to change without notice.