Tax Mechanics of Intra-Family Loans

This post was inspired by a post titled, “Lending Money to Family and Friends” on a great blog fivecentnickel.  

What are the Tax Mechanics of an Intra-Family Loan?

Let me say this first: This is not a post about whether one should make loans between family members or friends, as such you may find it surprisingly short.  If you’d like to talk about the emotions and/or if you should make a loan check out these posts (be sure to read the comments):

• Lending Money to Family and Friends – Fivecentnickel
• Family Money mangement – Helping Friends and Family in Financial Trouble – Gather Little by Little
• Loaning Family Money Part I and Part II – Budgets are Sexy

First thing is first, the IRS as an entity is not stupid.  They figured out a long time ago the problems which would happen if they allowed interest free loans.  So they implemented something known as the imputed interest rule also known as the Applicable Federal Rate.  There are three main categories, and each category changes monthly:

• Current Short Term AFRs for instruments having a term of three (3) years or less.
• Current Mid Term AFRs for instruments having a term in excess of three (3) years but no greater than nine (9) years.
• Current Long Term AFRs for instruments having a term in excess of nine (9) years.

It should be noted that AFRs are at historic lows and are routinely under a private loan rate.  For example for 9+ year loans created in April it is under 4%!  Want to look up some AFRs?

IRS Publication 550 provides some good insight:

Below-Market Loans

If you make a below-market gift or demand loan, you must report as interest income any forgone interest (defined later) from that loan. The below-market loan rules and exceptions are described in this section. For more information, see section 7872 of the Internal Revenue Code and its regulations.

If you receive a below-market loan, you may be able to deduct the forgone interest as well as any interest that you actually paid, but not if it is personal interest.

Loans subject to the rules. The rules for below-market loans apply to:

• Gift loans,
• Pay-related loans,
• Corporation-shareholder loans,
• Tax avoidance loans, and
• Certain loans made to qualified continuing care facilities under a continuing care contract.

A pay-related loan is any below-market loan between an employer and an employee or between an independent contractor and a person for whom the contractor provides services.

A tax avoidance loan is any below-market loan where the avoidance of federal tax is one of the main purposes of the interest arrangement.

Forgone interest. For any period, forgone interest is:

• The amount of interest that would be payable for that period if interest accrued on the loan at the applicable federal rate and was payable annually on December 31, minus
• Any interest actually payable on the loan for the period.

Exceptions to Intra Family Loans

In Publication 550 the IRS highlights some exceptions (I will only highlight 2 that are most likely applicable to the readers of this blog):

Exception for loans of $10,000 or less.

The rules for below-market loans do not apply to any day on which the total outstanding amount of loans between the borrower and lender is $10,000 or less. This exception applies only to:

1. Gift loans between individuals if the gift loan is not directly used to buy or carry income-producing assets, and
2. Pay-related loans or corporation-shareholder loans if the avoidance of federal tax is not a principal purpose of the interest arrangement.

This exception does not apply to a term loan described in (2) above that previously has been subject to the below-market loan rules. Those rules will continue to apply even if the outstanding balance is reduced to $10,000 or less.

Limit on forgone interest for gift loans of $100,000 or less.

For gift loans between individuals, if the outstanding loans between the lender and borrower total $100,000 or less, the forgone interest to be included in income by the lender and deducted by the borrower is limited to the amount of the borrower’s net investment income for the year. If the borrower’s net investment income is $1,000 or less, it is treated as zero. This limit does not apply to a loan if the avoidance of federal tax is one of the main purposes of the interest arrangement.

Well since, we all know that interest must be charged then what happens?

• The Lender has Taxable Income; and/or
• The Lender has made a Taxable Gift; and/or

Intra Family Loans in Estate Planning

It is a loan like any other loan – you can do balloon payment, amortization, or my personal fav Self Canceling Installment Notes (SCINs) etc.; however that being said the interest payments can be forgiven as a gift (but that gift is taxable).  As you may or may not be aware a donor, can give ANYONE up to $13K/yr; so if the payment is less than that it can be forgiven.  BE FOREWARNED the IRS has plenty of case law on their side throwing out fake loans and charging them against an estate.

Whether you should or shouldn’t is a different topic, but one should be aware of the ramifications of doing a major loan.  Comments? Concerns?