IRS tax attorneys warn that good-deed and loaning and/or borrowing money to/from a relative may create unexpected tax consequences. That’s right, the next time Uncle Toothless hits you up for a loan to buy that set of new dentures, or your kid needs money for those method acting lessons from an Ashton Kutcher want-to-be, IRS tax attorneys suggest you pay closer attention to a frequently overlooked corollary to loaning/borrowing money – taxes.
Most IRS tax attorneys will tell you that it’s hard to say precisely how many Americans loan/borrow money to/from their families, particularly during these difficult economic times. However, a few of these IRS tax attorneys point to a recent Australian study which suggests the average Aussie loans/borrows approximately $2,400 per year to/from family members.
According to these same IRS tax attorneys, the Australian study claims the most common reasons for borrowing money are unforeseen “emergency situations” (49%) or “running out of money” before payday (26%). Further, the IRS tax attorneys who’ve reviewed this study’s findings say that when it comes to hitting-up family members for dough, women appear to be roughly twice as likely as men to ask a family member for a loan. According to these same IRS tax attorneys, young adults, ages 18 to 24 years-old are the group most likely to need to borrow money from family members; and city dwellers are more likely than suburban or rural residents to ask for a loan, according to the study.
In the United States some IRS tax attorneys think baby-boomers are the most likely family members to be hit-up for loans. These same IRS tax attorneys say that when it happens, most boomers are woefully ignorant of the tax effects of providing such financial support to their families. In fact, several of these IRS tax attorneys rely on a report from the National Family Mortgage (a Boston-based service provider for inter-family home loans) to support their assertion. National Family Mortgage (NFM) claims it has funded $42 million in mortgage loans between family members, and the number of loans is growing.
Also significant, IRS tax attorneys report that NFM conducted a survey, in collaboration with Harris Interactive, which tracked the tax implications of family loans. These IRS tax attorneys claim there are several other recent, highly publicized surveys which “have reported that U.S. baby boomers are providing significant financial support to both their adult children and aging parents.” In fact, several IRS tax attorneys claim the report appropriately asserts that “while financial experts have expressed concern over boomers sacrificing their own retirement in order to help relatives, unsuspecting boomers may also be inviting IRS tax troubles as a result of this goodwill.”
IRS tax attorneys observe that often family members make loans to other members of the family without charging interest (or will charge an interest rate which is well below-market). These same IRS tax attorneys say when this happens you can be walking a virtual tightrope of tax related issues. As such, these IRS tax attorneys recommend that you consider upfront planning before deciding to make the loan to a family member.
Specifically, IRS tax attorneys claim it is critical you engage in advanced tax planning to avoid unexpected tax consequences when making loans to relatives. These IRS tax attorneys also say a key factor in how you structure the loan is the amount of interest you charge. IRS tax attorneys maintain that loans between family members where the interest charged will be below-market rates (in other words, you charge your relative no interest or at a rate below the Applicable Federal Rate (AFR)).
For those of you who might be interested in checking the current AFR, IRS tax attorneys direct you to www.irs.gov where the IRS publishes AFRs monthly on its website. IRS tax attorneys invite you to type “AFR” into the search window, and then click on “Index of Applicable Federal Rates.” IRS tax attorneys point out the relevant AFR for a particular loan is the one in effect for loans of that duration for the month the loan is made or for any of the three preceding months.
According to IRS tax attorneys consulted, the AFR applies to the life of the loan, regardless of interest rate fluctuations during that time. These IRS tax attorneys also point out, however, the exception is demand loans, for which the AFR is recalculated annually by “blending” the monthly short-term AFRs for that year. As long as you charge interest at or above the AFR, most IRS tax lawyers believe you should be relatively free of income tax and gift tax concerns. However, if you want to live life on the edge, i.e., charge less than the AFR, IRS tax attorneys strongly suggest you read on.
Most IRS tax attorneys will tell you that when you make a below-market loan to a relative or any other non-business party, the Internal Revenue Code treats you as making an “imputed gift” to your borrower. IRS tax attorneys are quick to add, that business-related loans follow similar concepts, except the offset is not a gift; instead, it is compensation or a capital-related item. IRS tax attorneys go on to explain that the “deemed” gift you make equals the difference between the AFR interest you should have charged and the interest you actually charged.
According to most IRS tax attorneys, the borrower in the above-scenario is then deemed to pay these phantom dollars back to you as “imputed interest,” and you must report the imputed interest as taxable income. To make matters worse, IRS tax attorneys add that when your imputed gift to the borrower exceeds $11,000, you will owe gift tax if you have exhausted your lifetime exemption.
IRS tax attorneys suggest that you can usually avoid most, if not all of these negative tax outcomes by taking advantage of two big exceptions. The first exception IRS tax attorneys look to is the “$10,000 Rule.” For small loans, IRS tax attorneys say the IRS will let you ignore the imputed gift and imputed interest income rules. However, the total of loans between you and the borrower must be $10,000 or less. IRS tax attorneys note that the $10,000 aggregate loan limit applies to all outstanding loans between you and the borrower, whether or not you charged interest equal to or above the AFR.
The other exception IRS tax attorneys rely upon is the “$100,000 Rule.” Obviously, the $10,000 rule is no help with bigger loans. Fortunately, in many cases according to IRS tax attorneys the $100,000 rule will keep you out of trouble. IRS tax attorneys go on to say that you are eligible for the $100,000 rule as long as the aggregate balance of all outstanding loans (below-market or otherwise) between you and the borrower is $100,000 or less.
For income tax purposes, IRS tax attorneys claim the taxable imputed interest income to you is zero, as long as the borrower’s net investment income for the year is no more than $1,000. (Net investment income is the same figure used to determine how much broker margin account interest can be deducted currently on your itemized deduction Schedule A.) IRS tax attorneys go on to say that if the borrower’s net investment income exceeds $1,000, then your taxable imputed interest income is limited to no more than his or her actual net investment income. Further, IRS tax attorneys caution that the borrower must give you an annual signed statement disclosing his or her net investment income for the year. Be sure to keep this document with your tax records.
IRS tax attorneys mention that although these above-referenced exceptions address the matter of income taxes, gift tax issues remain. For gift taxes, IRS tax attorneys explain the $100,000 rule can be tricky. IRS tax attorneys recommend you designate your below-market or interest-free loan as a demand loan. According to these IRS tax attorneys, this allows you to demand full repayment anytime you want, even though you and the borrower may have informally agreed on a payment schedule.
With a demand loan, IRS tax attorneys explain the imputed gift amount is calculated year-by-year and is equal to the imputed interest for that year. As long as interest rates remain anywhere close to today’s rates, several IRS tax attorneys content that the annual imputed gift on a $100,000 loan should be well under the $11,000 annual limit for tax-free gifts.
In contrast, most IRS tax attorneys say that when you make a below-market or interest-free term loan, the gift tax rules are much less favorable. To illustrate their point, these IRS tax attorneys ask you to assume you make a $100,000 interest-free loan calling for a balloon repayment after seven years. IRS tax attorneys describe this as a term loan (as is a loan calling for installment principal payments). Essentially, according to several IRS tax attorneys you’re treated as making an immediate imputed gift to the borrower equal to seven years’ worth of imputed interest.
With respect to a $100,000 term loan, most IRS tax attorneys caution your imputed gift in the year the loan is made may well exceed the $11,000 annual exclusion. These IRS tax attorneys claim that you’ll either owe current gift taxes or use-up part of your lifetime exemption. Again, these IRS tax attorneys maintain that you can avoid both of these adverse outcomes simply by making a demand loan instead of a term loan. As long as you contractually retain demand rights on the loan, informal payment terms that are not otherwise legally enforceable should not affect the demand loan classification.
While most IRS tax attorneys acknowledge everyone has a relative who’s short of cash, these same IRS tax attorneys say that before you write that check, be sure to follow some common-sense rules. As noted above, uniformly IRS tax attorneys say that loans to family members touch on two sensitive areas of interest to the IRS, specifically: gifts and interest income.
IRS tax attorneys first recommend that you “Document the Loan.” The first step to avoiding trouble according to most IRS tax attorneys is to clearly document that the money is actually a loan, with or without interest. IRS tax attorneys advise that the documentation should also include payment terms and the collateral for the loan, if any. IRS tax attorneys claim this will avoid conflict about what exactly the borrower agreed to pay. And, if you don’t do this, the lender could find himself/herself/itself paying income taxes on interest he/she/it never received and gift taxes on money he/she/it never gave away. And, IRS tax attorneys warn in cases involving a long term the loan, it could cut into the lender’s gift and estate tax exemptions.
The majority of IRS tax attorneys will tell you that you don’t need a lawyer to draw up the documentation. In fact, most IRS tax attorneys would tell you that you can easily satisfy the IRS with a do-it-yourself document.
Next, most IRS tax attorneys recommend that you “Secure the Note.” Here, the vast majority of IRS tax attorneys will tell you that if you are borrowing money to buy a new home, you should take the extra step of legally securing the note with your residence. (IRS tax attorneys say this may require a lawyer and you should seek professional advice before deciding whether to use your home as security on a note.) That way, the IRS tax attorneys claim that you can take advantage of one of the most popular tax deductions: interest on a home mortgage. IRS tax attorneys caution anyone thinking of not reporting a family loan when applying for a mortgage should consider this point: You could face criminal charges if you falsify a mortgage application to hide the origin of your down-payment money.
IRS tax attorneys also recommend that you “Establish Solvency.” In order to clarify that the loan is not a gift, many IRS tax attorneys recommend the lender write a memo establishing that the borrower was solvent at the time of the loan. IRS tax attorneys assert that this helps to prove the lender had a reasonable expectation of repayment and was not actually making a gift.
Another important recommendation from most IRS tax attorneys is to “Set an Interest Rate.” IRS tax attorneys often quip that interest-free doesn’t mean hassle-free. These same IRS tax attorneys point out that most loans among family members are interest-free, but be careful because if you don’t set an interest rate, the IRS will do it for you.
And since the interest rate the IRS selects for the loan would be considered income to the lender, IRS tax attorneys point out the IRS will gladly tax the interest payments the borrower were never paid to the lender. IRS tax attorneys say welcome – you’ve entered the surprisingly complex and bizarre world of “imputed interest.” IRS tax attorneys explain that the federal government, eager to raise revenue, has decided that for a loan to be a loan, interest must be paid, and if interest is being paid, then someone is making taxable income and should be taxed.
IRS tax attorneys jokingly suggest the government’s enthusiasm for collecting your tax dollars does not stop there. Not only does the IRS place a tax on imaginary interest income you never charged the borrower; but IRS tax attorneys claim the IRS then further assumes that the borrower could not afford to make the interest payments; and so the Agency acts as if the lender gave the borrower the money to pay the interest as a gift, thereby triggering the specter of another taxing opportunity (gift taxes). So, according to most IRS tax attorneys the money the lender never received but pays taxes on anyway could also count against the $11,000 annual tax-free gift limit. IRS tax attorneys warn that if the imaginary interest payments exceed that gift limit, then it is likely taxes and possibly penalties will be due. Many IRS tax attorneys assure this is not all as bad as it sounds, and in most cases taxes and/or penalties can be avoided with good planning.
IRS tax attorneys also suggest that you seek to “Avoid Imputed Interest.” IRS tax attorneys generally maintain that imputed interest and all the crazy imputed income and gift tax problems generally do not apply when a loan totals less than $10,000. However, several IRS tax attorneys caution that you should watch out because the $10,000 limit applies to all outstanding loans between borrower and the lender, including those interest charges (real or imaginary). But, according to many IRS tax attorneys there is possible relief if the $10,000 rule does not help, you may be able to turn to the $100,000 rule.
As noted above, IRS tax attorneys point out the $100,000 rule applies when the aggregate balance of all outstanding loans (interest-free or otherwise) between the borrower and the lender is $100,000 or less. For income tax purposes, IRS tax attorneys say the amount of imputed interest is zero if the borrower’s net investment income for the year is no more than $1,000. (Net investment income, which includes interest, dividends and certain royalties, but not necessarily capital gains, is the figure used to determine how much margin-account interest can be deducted on Schedule A.) Since most people who borrow money from family members are probably not sitting on large investment portfolios, IRS tax attorneys maintain that imputed interest can generally be avoided.
Under the $100,000 rule, IRS tax attorneys explain that when the borrower’s net investment income exceeds $1,000, imputed interest is limited to the actual amount of investment income. IRS tax attorneys offer the following example: If a father lends his daughter $100,000 interest-free but the IRS sets an interest rate of 5 percent, then the father would have to declare imputed interest payments of $5,000. But if the daughter’s investment income is less than $1,000, the imputed interest would be zero. If the daughter earned $1,500 in interest income, the father would have to pay taxes on only $1,500 rather than $5,000. Significantly, IRS tax attorneys remind you that to qualify for the $100,000 rule, the lender must collect an annual statement that discloses the borrower’s net investment income.
IRS tax attorneys also encourage you to “Insist on a Demand Loan.” IRS tax attorneys advise that the $100,000 rule gets really complicated when it comes to the gift tax. IRS tax attorneys are quick to point out the net investment income rule does not apply here. To minimize gift tax problems, several IRS tax attorneys recommend that you designate the interest-free advance as a “demand loan.” This means the lender can demand full repayment at any time. While this may seem unduly threatening, IRS tax attorneys say it could save the lender money because of the way the IRS calculates the imputed gift. While many IRS tax attorneys say the lender/borrower can still informally agree on a repayment schedule, with a demand loan the amount of the imputed gift is calculated on a yearly basis and should total less than $11,000 a year. IRS tax attorneys argue that the imputed gift for each year the loan is outstanding will most probably fall harmlessly below the $11,000 annual limit for tax-free gifts.
As you might expect, however, IRS tax attorneys are quick to remind everyone that if you do not designate the loan as a “demand loan”, the IRS will add-up all the interest the borrower would have paid to the lender during the life of the loan and count it as a gift from the lender during the tax year the loan was made. IRS tax attorneys say the result could be a relatively large imputed gift that exceeds the $11,000 annual tax-free limit, and also cuts into the lender’s gift and estate tax exemptions.
IRS tax attorneys caution these rules can get very complicated and slippery, particularly for the uninitiated. So most IRS tax attorneys say it’s probably a good idea to consult a tax professional before deciding on and/or drawing up this kind of loan agreement. Again, IRS tax attorneys reiterate that you may avoid all these hassles if you simply charge interest on that family loan.
Earlier in this article we discussed how the IRS uses what it calls applicable federal rates (AFRs), which change monthly, to determine if the interest rate is proper. If the lender charges at least the applicable federal rates, the vast majority of IRS tax attorneys say the lender simply reports the interest payments as taxable income.
Several IRS tax attorneys were asked: “What if the Borrower Defaults on the Loan?” As we all know, there are few things that hurt family relations more than bad debts. But IRS tax attorneys claim the Agency is not ashamed to get involved. If the lender tries to write off the borrower’s bad debt on the lender’s tax return, the IRS will then seek to collect the lost tax from the borrower.
Think it won’t happen? A few IRS tax attorneys cite a 1995 U.S. Tax Court case which involved a father who made thousands of dollars in undocumented loans to his 23-year-old daughter, who wanted to open a roller-skating rink. Evidently, the skating rink failed and the father claimed a $35,000 nonbusiness bad-debt deduction, even though no formal collection efforts were undertaken against his daughter. (Significantly, the daughter had filed for bankruptcy four months earlier.) The Tax Court concluded that the advances were loans because of “loan” notations the father had made on some of the checks, and because the father had previously made undocumented loans to family members and friends and had been repaid. So the IRS’s collection efforts against the daughter were approved.
While a few IRS tax attorneys suggest the foregoing represents an isolated, extreme example, almost without exception all IRS tax attorneys agree you should seek professional advice when contemplating a loan to family members, particularly if the loan is going to be a larger amount. IRS tax attorneys appear to uniformly agree that good, advanced tax planning and appropriate, accurate documentation should go a long way to avoiding future tax problems and helping to maintain better familial relations.