Think Twice Before Making Interest Free Loans To Loved Ones
These pandemic times have hit many family members hard. We all want to be generous to our kids and grandkids who are out of work, be helpful to that brother or sister that got the virus, and financially support our elderly parents in quarantine for their safety, BUT most folks do not realize what is involved in making a sizable loan to a loved one. Of course you expect to be repaid. But if there is no specific time for repayment and the loan carries no interest, are there tax consequences for giving cask to your kin? Yes indeed!
Some folks think they can give large amounts of money to their children and call it a loan to avoid the hassle of filing a gift tax return. The IRS is hard to fool. When you make a non-interest-bearing loan there are various tax consequences. The borrower is treated as having made interest payments to the lender, based on IRS-prescribed interest rates (around 2.35 to 2.70%) known as the Applicable Federal Rate. Unless the loan does not exceed $10,000, and the loan is not directly attributable to the purchase or carrying of an income-producing asset, then the interest rate can be below market and no imputed interest will be required to be calculated.
In the case of a parent-child loan, the imputed interest represents taxable income to the parent. Even though the parent will not actually receive any interest payments, the parent must nevertheless report the amount each year as taxable income on their personal income tax returns and pay tax on it. The parent has to file a gift tax return if the imputed interest exceeds the annual gift tax exclusion, which is $15,000 per donor. That can be doubled if a husband and wife each make such a gift, to $30,000 annually. Odds are you as the parent won’t have to pay a dime in gift tax, even if the loan amount—also known as a gift, for tax purposes—exceeds $15,000, or $30,000 if from a married couple. The amount is excluded from your lifetime gift tax exemption.
If gift tax consequences are a concern, have your child start paying interest to you each year until the loan is fully repaid. You can increase the loan amount to provide additional cash to your child to cover the interest payments. While the interest will still be subject to income tax, you can at least avoid the gift tax filing and any unintended use of your estate and gift tax exemption.
How to handle the paperwork for such loans and avoid tax traps? Appropriate documentation should be in place to establish the principal repayment obligation, otherwise the IRS might claim that the full amount of the loan you made was a gift.
- Create a promissory note or similar document setting up your loved one’s obligation to repay the loan to you.
- Set the rate at or above the Applicable Federal Rate (AFR) in effect when the loan is originated.
- Maintain records that reflect a true loan transaction, including timely payments.
If there is no specific repayment date, the promissory note can provide for payment to be made upon demand by you as lender. Hence, the debt will become due and required to be repaid when you choose. This way, you gain the flexibility of not being tied to a specific repayment schedule.
Do not have a prearranged schedule to forgive the loan. Forgiveness is okay as long as it is not expected or prearranged. If your loved one refuses to repay the loan to you, or dies before you, you can at least show you have a formal arrangement in place, and the transferred money was indeed a loan. That avoids complications.
One of the advantages of a loan contract is that if your child doesn’t pay, you can take a deduction for a non-business bad debt. Additionally, you don’t have to pay gift tax to the IRS on the amount like you would if you had gifted the money. To take a bad debt deduction, you must prove that you tried to collect the debt. The debtor should make a written statement that he or she cannot pay. The statement should also include a reason for why they are unable to make the payments.