It is fairly common for family members to loan money to each other. These loans can be made to help a family member start a business, buy a home or car, or make other large purchases. These loans can also be made for financial gain. For example, a parent earning 1% on a certificate of deposit can loan money to a child at 3% interest when the child would otherwise pay 6% on a loan and both parties would therefore benefit.
Make Sure You Charge a Minimum Amount of Interest
It is very important to know that the IRS requires a minimum amount of interest to be charged on related party loans. A primary concern is that the lender creates a benefit for the borrower in the form of an interest free loan. The IRS wants to make sure this benefit is recognized as a gift for gift tax purposes.
The minimum amount of interest that must be charged is calculated based on what is known as the applicable federal rate (AFR). When the interest rate charged in related party loans is less than the AFR, the IRS treats the loan as if it had been made at the AFR and recasts the loan as an arm’s-length transaction. The additional amount of interest that must be charged is known as imputed interest.
The IRS does this by computing interest at the AFR and comparing it to the actual rate of interest charged, if any. The excess interest charged under the AFR is imputed interest and is treated as a gift from the lender to the borrower. This gift may be subject to gift tax.
The borrower is then deemed to make an equal interest payment back to the lender. The lender will have taxable interest income. Depending on the use of the borrowed funds, the borrower may or may not be able to deduct the deemed interest paid. If the borrower uses the loan for business purposes, the deemed interest will be deductible as a business expense. If the borrower uses the loan to make investments, the deemed interest will be treated as investment interest expense (which is deductible only to the extent of investment income). If the borrower uses the loan for personal reasons, the deemed interest payment is not deductible.
A Bad Debt Deduction May be Possible
If properly structured, loans from one family member to another are treated as an arm’s-length transaction that entitles the lender to a bad debt deduction if the borrower fails to repay the loan. In this case, the borrower may have discharge of indebtedness income.
Example: Andy loans $200,000 to his son, Opie to start a business. The loan is interest free. The IRS requires interest to be charged on this loan. Based on the AFR rate of 2.8%, the interest for the year should be $5,600. Andy is deemed to gift $5,600 to his son. Since this is Andy’s only gift during the year and its amount is under the $14,000 annual gift tax exclusion, it is a nontaxable gift and Andy does not have to file a gift tax return.
Next, Opie is deemed to have paid the $5,600 gift back to Andy as interest. Andy will have $5,600 of interest income.
Finally, Opie will be able to deduct the $5,600 interest payment since the loan was made to start a business. If Opie borrowed the money for personal reasons, the deemed interest payment would be a nondeductible personal expense.
Exceptions to the Imputed Interest Rules
Luckily, there are exceptions to the imputed interest rules. The exceptions are:
- Loans not exceeding $10,000 between individuals is not subject to the imputed interest rules.
- A special rule applies for loans between individuals that do not exceed $100,000. Under this rule, the imputed interest on the loan will not exceed the borrower’s net investment income during the year. Where the borrower’s net investment income is less than $1,000, the borrower is treated as having no net investment income and will therefore have no imputed interest.
Example: Andy loans his son, Opie, $9,000 and charges no interest. Since the amount of the loan is less than $10,000, Andy and Opie will not be subject to the imputed interest rules.
Example 2: Andy loans his son, Opie, $90,000 and charges no interest. Opie has $1,200 net investment income for the year. The imputed interest based on the AFR is $2,520. However, since the amount of the loan is under $100,000 the imputed interest is limited to Opie’s net investment income of $1,200.
Example 3: Same facts as Example 2 except that Opie’s net investment income is $900. Since the amount of the loan is under $100,000 and Opie’s net investment income is under $1,000, there is no imputed interest.
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Buzzkill Disclaimer: This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.