When a family member experiences hard times, other family members might be quick to lend them whatever amount they need. After all … they’re family. But Uncle Sam keeps an eye on such transactions. Why? Because they might not, for tax purposes, be loans. The IRS might consider them taxable gifts.
By formalizing such transactions as loans, you can avoid triggering gift taxes. But even when a transaction qualifies as a loan, there are additional tax issues you need to be aware of.
Loans vs. gifts
The IRS and courts look at several factors in determining whether a transaction is a loan or a gift. An intrafamily loan is more likely to be viewed as bona fide if there’s a written agreement, interest is charged and there’s a fixed repayment schedule. In addition, the borrower should execute a promissory note and actually make the payments.
Not all of these factors must be present, but, the more there are, the better your chances of the loan withstanding IRS scrutiny. Nevertheless, the IRS still can recharacterize a loan as a gift if it determines that the loan’s purpose was to avoid taxes.
Charging enough interest
Even if an intrafamily transaction is a loan, you must charge adequate interest or the loan could be considered “below market” and trigger gift taxes. A loan is below market if you charge less than a minimum interest rate, which is determined by the applicable federal rate (AFR).
For example, the minimum rate for a demand loan (one that’s payable on demand or has an indefinite maturity) is the short-term AFR, compounded semiannually. So, the minimum rate varies during the life of the loan. To ensure you charge enough interest for a demand loan, use a variable rate that’s tied to the AFR. For a loan with a set term, use the AFR that’s in effect on the loan date.
Tax consequences of below-market loans
Below-market loans to family members have not only gift tax consequences but also income tax consequences, and they differ depending on the loan type. For a demand loan, each tax year you’re treated as if: 1) you’d made a taxable gift equal to the amount of imputed interest, and 2) the borrower transferred the money back to you as an interest payment.
Imputed interest is the difference between the AFR and the interest you actually collect, recalculated annually. Depending on the loan’s purpose, the borrower may be able to deduct this interest.
If interest is imputed to you, you’ll owe income taxes on the fictitious payments. Plus, there may be gift tax consequences if the imputed interest exceeds the annual gift tax exclusion ($14,000 for 2013).
There are two exceptions that allow you to avoid the imputed interest rules — or at least lessen their impact: 1) Loans up to $10,000 are generally exempt and 2) loans up to $100,000 are exempt if the borrower’s net investment income for the year is $1,000 or less. If net investment income exceeds $1,000, the imputed interest rules apply, but the amount of interest is limited to the amount of net investment income.
Term loans are treated much the same way as demand loans for income tax purposes. But the gift tax consequences are different. If you make a below-market term loan to a family member, your gift is equal to the excess of the loan amount over the present value of all future loan payments (using the AFR as the discount rate).
If you make a low-interest or no-interest loan to a family member, avoid a term loan so you don’t make a substantial upfront gift.
Be generous, but careful
It’s wonderful to help a family member in need. But be sure you handle intrafamily loans wisely and work with your tax advisor, so you can avoid an unexpected tax liability and any associated interest and penalties that could be assessed.