Let’s say you want to lend a significant amount of money to your child, another family member or even a friend. To further help, you decide that you want to make the loan without interest (or at a below-market rate). Bully for you – you should be commended for your support and assistance to your “lendee”!
However, before you write that check, it is important to consider the tax consequences. It’s one thing to be a generous benefactor, but it’s another to do so without fully understanding its effects. The IRS may have something to say about your arrangement if you haven’t put it together carefully.
The following is a brief and simplified discussion of some best practices for setting up your loan, as well as the main tax consequences that can result. If any of this appears to apply in your situation, be sure to do your due diligence before moving forward.
Best Practices for Proving Your Loan is a Loan
First and foremost, for the IRS to even consider your transaction a loan and not an outright gift of the amount given, it must be a real debt. As outright gifts can result in gift tax consequences, especially for transactions exceeding $13,000 in one year, loan treatment is generally preferred.
You lend further credence to the transaction being a debt if it is in writing, preferably including:
- A provision stating the interest rate of the debt. If the loan is to be interest-free, be sure to state in the writing that the debt is to be paid back without interest.
- A repayment schedule.
- A signature by the party borrowing the money. This is the borrower’s promise to pay the amount back.
Also, it is best for the lender to keep records of the amount and date of the loan, each installment payment, and a running balance of how much is still owed.
Remember, the more documentation you create, the more proof there will be in your favor. The more proof, the more likely that the IRS will treat your deal as a debt and not as an outright gift.
Taxes on “Imputed Income”
Technically, when you make a no-interest or below-market interest loan, you are still required to report the interest you would have earned had you charged a market rate of interest. This amount that must be declared is referred to as “imputed interest”.
An oversimplified example is probably warranted:
- Let’s say that on January 1, 2011, Fred Shepherd gave his daughter Ima a no-interest loan of $200,000. He requires her to pay back $2,000 per month for 100 months, starting in January 2012.
- Let’s further say that the market rate of interest on the date of the loan is 2% (in this case, it would actually have been 1.95%).
- At the end of 2011, per the loan agreement, Ima has paid back $0.
- However, Fred would need to “impute” (i.e. declare) 2% of $200,000, or $4,000, of interest income on his 2011 federal tax return, even though he did not actually receive any cash from Ima during 2011.
A warning – it is not uncommon for the borrower to feel bad and therefore offer to pay the additional tax owed by the lender. However, this could also be deemed as income to the lender, thereby worsening the problem!
- From our example above, say Fred owes an additional $1,000 in taxes as a result of the imputed interest he must declare. If Ima gives Fred the $1,000, Fred may have to declare that as income as well and possibly owe even more tax.
So how do you find out the proper rate of interest? Each month, the IRS releases the “Applicable Federal Rate” (AFR) for the following month. All monthly AFRs since January 2000 are posted on the IRS website.
The Limited Exceptions
Some loans are exempt from the imputed income rules state above. In other words, for the following loans, the lender is able to limit or even eliminate the requirement to report imputed interest:
- Certain loans for $10,000 or less.
- Certain loans to continuing care facilities if the lender or spouse is 62 or older.
- Potential limitations to the rules exist if loans between the lender and borrower total $100,000 or less.
For further details, see IRS Publication 550, under the “Interest Income – Below-Market Loans” section.
- Caution on Interest Free Demand Loans to Family Members (pennsylvaniatrustsandestates.com)
- U.S. News and World Report (dedononestateplanning.typepad.com)
- IRS Interest Rates Drop to New All-Time Low (tennesseeestateplanninglaw.com)