Beware Of No-Interest Family Loans
No good deed goes unpunished, or so the saying goes. You face painful tax consequences if you mishandle a loan to a relative.
Say your daughter wants to buy a condo. You loan her $500,000, payable in five years. And you don't charge her any interest.
"The IRS will impute interest on such loans," said Albert Ellentuck, an attorney with King & Nordlinger in Arlington, Va.
Imputed interest will be set at applicable federal rates, or AFRs, posted monthly at irs.gov.
Currently, the AFR on loans from three to nine years is about 5%. So you would have imputed annual interest of $25,000. That's 5% of $500,000.
The tax treatment is costly. First, you would have to recognize $25,000 of interest income yearly. You would owe tax on that amount even though you collected no cash.
Second, the IRS will say you gave your daughter a $25,000 gift for each year of the loan -- because you didn't charge interest. You would have to file a gift tax return.
And you'd have to pay gift tax, if you have used up your $1 million lifetime gift tax exclusion. Even if you don't have to pay gift tax, such gifts will cut your estate tax exclusion.
In contrast, tax rules treat your daughter generously. If she uses your loan for an eligible purpose, like buying a home, she may be able to take a $25,000 deduction for the imputed interest. She can take that deduction even though she is not actually paying interest.
She can do that even if she uses the loan for certain other purposes, such as buying stock or starting a business. Generally, she can take a deduction if:
An actual interest payment would have been deductible.
She had actually paid interest.
Loans for other purposes might not generate a tax deduction. For instance, imputed interest on a loan for taking a vacation would not be deductible.
Can you avoid such tax pitfalls? It may be easier in the case of smaller loans with:
The $10,000 loophole. "If the money you loan to a relative doesn't exceed $10,000, no interest will be imputed," said Ellentuck. This loan can't be used for income-producing investments.
If the loan is for income-producing investments, interest would be imputed. And it would be taxable.
Say you loan your son $10,000 to buy a car. Even if you don't charge any interest, no interest will be imputed.
The $100,000 loophole. Loans up to $100,000 also can escape income tax. That's the case if the borrower's net investment income is no more than $1,000 each year.
Net investment income generally includes interest, dividends and short-term capital gains. From that total you subtract any investment interest you paid.
Say you loan your daughter $100,000 to buy that condo. Her net investment income is $800 this year. No income tax will be imputed. But next year your daughter's net investment income is $1,200. You will have to pay that amount or the AFR rate, whichever is lower.
If the AFR rate is 5%, that would be $5,000 on a $100,000 loan. So $1,200 in imputed income would be taxed to you that year.
The two exceptions described above are only for income tax purposes. Interest-free loans would still have gift tax consequences.
The same is true for below-market loans. If you loan money to your daughter at 2% when the AFR is 5%, the 3% gap will be imputed.
Income tax may be avoided by using either of those two loopholes, but gift tax will apply on the 3% gap.
The annual gift tax exclusion can help you avoid some problems. You can give up to $12,000 a year to each of any number of recipients, without incurring any gift tax. For married couples, the number is $24,000.
Only excess amounts over either annual cap count against the $1 million lifetime exclusion.
To avoid income and gift tax complications, your best strategy may be to charge your relatives the going interest rate and collect it regularly.
"All parties to the loan should sign a written agreement, spelling out terms of the loan," Ellentuck said. And those terms should be followed.
If you do not have a formal loan agreement and no interest has been paid, the IRS may say the transaction was a gift, not a loan. The entire amount could be called a gift, which could trigger a gift tax.
Coping Tactic
One tactic is to call the debt a demand loan rather than a term loan. A demand loan has no specific maturity date. And it is payable in full whenever the lender demands it. Yet a borrower may pay it off early, without a prepayment penalty.
This type of a loan is considered short term by the IRS. Short-term loans usually have lower interest rates than mid- and long-term loans. That may make it easier for your child to make the required payments.
If your child pays a market rate of interest, no income or gift tax will be imputed. You'll have taxable interest income, and your child may get to deduct interest that's paid.
Say your daughter wants to buy a condo. You loan her $500,000, payable in five years. And you don't charge her any interest.
"The IRS will impute interest on such loans," said Albert Ellentuck, an attorney with King & Nordlinger in Arlington, Va.
Imputed interest will be set at applicable federal rates, or AFRs, posted monthly at irs.gov.
Currently, the AFR on loans from three to nine years is about 5%. So you would have imputed annual interest of $25,000. That's 5% of $500,000.
The tax treatment is costly. First, you would have to recognize $25,000 of interest income yearly. You would owe tax on that amount even though you collected no cash.
Second, the IRS will say you gave your daughter a $25,000 gift for each year of the loan -- because you didn't charge interest. You would have to file a gift tax return.
And you'd have to pay gift tax, if you have used up your $1 million lifetime gift tax exclusion. Even if you don't have to pay gift tax, such gifts will cut your estate tax exclusion.
In contrast, tax rules treat your daughter generously. If she uses your loan for an eligible purpose, like buying a home, she may be able to take a $25,000 deduction for the imputed interest. She can take that deduction even though she is not actually paying interest.
She can do that even if she uses the loan for certain other purposes, such as buying stock or starting a business. Generally, she can take a deduction if:
An actual interest payment would have been deductible.
She had actually paid interest.
Loans for other purposes might not generate a tax deduction. For instance, imputed interest on a loan for taking a vacation would not be deductible.
Can you avoid such tax pitfalls? It may be easier in the case of smaller loans with:
The $10,000 loophole. "If the money you loan to a relative doesn't exceed $10,000, no interest will be imputed," said Ellentuck. This loan can't be used for income-producing investments.
If the loan is for income-producing investments, interest would be imputed. And it would be taxable.
Say you loan your son $10,000 to buy a car. Even if you don't charge any interest, no interest will be imputed.
The $100,000 loophole. Loans up to $100,000 also can escape income tax. That's the case if the borrower's net investment income is no more than $1,000 each year.
Net investment income generally includes interest, dividends and short-term capital gains. From that total you subtract any investment interest you paid.
Say you loan your daughter $100,000 to buy that condo. Her net investment income is $800 this year. No income tax will be imputed. But next year your daughter's net investment income is $1,200. You will have to pay that amount or the AFR rate, whichever is lower.
If the AFR rate is 5%, that would be $5,000 on a $100,000 loan. So $1,200 in imputed income would be taxed to you that year.
The two exceptions described above are only for income tax purposes. Interest-free loans would still have gift tax consequences.
The same is true for below-market loans. If you loan money to your daughter at 2% when the AFR is 5%, the 3% gap will be imputed.
Income tax may be avoided by using either of those two loopholes, but gift tax will apply on the 3% gap.
The annual gift tax exclusion can help you avoid some problems. You can give up to $12,000 a year to each of any number of recipients, without incurring any gift tax. For married couples, the number is $24,000.
Only excess amounts over either annual cap count against the $1 million lifetime exclusion.
To avoid income and gift tax complications, your best strategy may be to charge your relatives the going interest rate and collect it regularly.
"All parties to the loan should sign a written agreement, spelling out terms of the loan," Ellentuck said. And those terms should be followed.
If you do not have a formal loan agreement and no interest has been paid, the IRS may say the transaction was a gift, not a loan. The entire amount could be called a gift, which could trigger a gift tax.
Coping Tactic
One tactic is to call the debt a demand loan rather than a term loan. A demand loan has no specific maturity date. And it is payable in full whenever the lender demands it. Yet a borrower may pay it off early, without a prepayment penalty.
This type of a loan is considered short term by the IRS. Short-term loans usually have lower interest rates than mid- and long-term loans. That may make it easier for your child to make the required payments.
If your child pays a market rate of interest, no income or gift tax will be imputed. You'll have taxable interest income, and your child may get to deduct interest that's paid.
No good deed goes unpunished, or so the saying goes. You face painful tax consequences if you mishandle a loan to a relative.
Say your daughter wants to buy a condo. You loan her $500,000, payable in five years. And you don't charge her any interest.
"The IRS will impute interest on such loans," said Albert Ellentuck, an attorney with King & Nordlinger in Arlington, Va.
Imputed interest will be set at applicable federal rates, or AFRs, posted monthly at irs.gov.
Currently, the AFR on loans from three to nine years is about 5%. So you would have imputed annual interest of $25,000. That's 5% of $500,000.
The tax treatment is costly. First, you would have to recognize $25,000 of interest income yearly. You would owe tax on that amount even though you collected no cash.
Second, the IRS will say you gave your daughter a $25,000 gift for each year of the loan -- because you didn't charge interest. You would have to file a gift tax return.
And you'd have to pay gift tax, if you have used up your $1 million lifetime gift tax exclusion. Even if you don't have to pay gift tax, such gifts will cut your estate tax exclusion.
In contrast, tax rules treat your daughter generously. If she uses your loan for an eligible purpose, like buying a home, she may be able to take a $25,000 deduction for the imputed interest. She can take that deduction even though she is not actually paying interest.
She can do that even if she uses the loan for certain other purposes, such as buying stock or starting a business. Generally, she can take a deduction if:
An actual interest payment would have been deductible.
She had actually paid interest.
Loans for other purposes might not generate a tax deduction. For instance, imputed interest on a loan for taking a vacation would not be deductible.
Can you avoid such tax pitfalls? It may be easier in the case of smaller loans with:
The $10,000 loophole. "If the money you loan to a relative doesn't exceed $10,000, no interest will be imputed," said Ellentuck. This loan can't be used for income-producing investments.
If the loan is for income-producing investments, interest would be imputed. And it would be taxable.
Say you loan your son $10,000 to buy a car. Even if you don't charge any interest, no interest will be imputed.
The $100,000 loophole. Loans up to $100,000 also can escape income tax. That's the case if the borrower's net investment income is no more than $1,000 each year.
Net investment income generally includes interest, dividends and short-term capital gains. From that total you subtract any investment interest you paid.
Say you loan your daughter $100,000 to buy that condo. Her net investment income is $800 this year. No income tax will be imputed. But next year your daughter's net investment income is $1,200. You will have to pay that amount or the AFR rate, whichever is lower.
If the AFR rate is 5%, that would be $5,000 on a $100,000 loan. So $1,200 in imputed income would be taxed to you that year.
The two exceptions described above are only for income tax purposes. Interest-free loans would still have gift tax consequences.
The same is true for below-market loans. If you loan money to your daughter at 2% when the AFR is 5%, the 3% gap will be imputed.
Income tax may be avoided by using either of those two loopholes, but gift tax will apply on the 3% gap.
The annual gift tax exclusion can help you avoid some problems. You can give up to $12,000 a year to each of any number of recipients, without incurring any gift tax. For married couples, the number is $24,000.
Only excess amounts over either annual cap count against the $1 million lifetime exclusion.
To avoid income and gift tax complications, your best strategy may be to charge your relatives the going interest rate and collect it regularly.
"All parties to the loan should sign a written agreement, spelling out terms of the loan," Ellentuck said. And those terms should be followed.
If you do not have a formal loan agreement and no interest has been paid, the IRS may say the transaction was a gift, not a loan. The entire amount could be called a gift, which could trigger a gift tax.
Coping Tactic
One tactic is to call the debt a demand loan rather than a term loan. A demand loan has no specific maturity date. And it is payable in full whenever the lender demands it. Yet a borrower may pay it off early, without a prepayment penalty.
This type of a loan is considered short term by the IRS. Short-term loans usually have lower interest rates than mid- and long-term loans. That may make it easier for your child to make the required payments.
If your child pays a market rate of interest, no income or gift tax will be imputed. You'll have taxable interest income, and your child may get to deduct interest that's paid.
Say your daughter wants to buy a condo. You loan her $500,000, payable in five years. And you don't charge her any interest.
"The IRS will impute interest on such loans," said Albert Ellentuck, an attorney with King & Nordlinger in Arlington, Va.
Imputed interest will be set at applicable federal rates, or AFRs, posted monthly at irs.gov.
Currently, the AFR on loans from three to nine years is about 5%. So you would have imputed annual interest of $25,000. That's 5% of $500,000.
The tax treatment is costly. First, you would have to recognize $25,000 of interest income yearly. You would owe tax on that amount even though you collected no cash.
Second, the IRS will say you gave your daughter a $25,000 gift for each year of the loan -- because you didn't charge interest. You would have to file a gift tax return.
And you'd have to pay gift tax, if you have used up your $1 million lifetime gift tax exclusion. Even if you don't have to pay gift tax, such gifts will cut your estate tax exclusion.
In contrast, tax rules treat your daughter generously. If she uses your loan for an eligible purpose, like buying a home, she may be able to take a $25,000 deduction for the imputed interest. She can take that deduction even though she is not actually paying interest.
She can do that even if she uses the loan for certain other purposes, such as buying stock or starting a business. Generally, she can take a deduction if:
An actual interest payment would have been deductible.
She had actually paid interest.
Loans for other purposes might not generate a tax deduction. For instance, imputed interest on a loan for taking a vacation would not be deductible.
Can you avoid such tax pitfalls? It may be easier in the case of smaller loans with:
The $10,000 loophole. "If the money you loan to a relative doesn't exceed $10,000, no interest will be imputed," said Ellentuck. This loan can't be used for income-producing investments.
If the loan is for income-producing investments, interest would be imputed. And it would be taxable.
Say you loan your son $10,000 to buy a car. Even if you don't charge any interest, no interest will be imputed.
The $100,000 loophole. Loans up to $100,000 also can escape income tax. That's the case if the borrower's net investment income is no more than $1,000 each year.
Net investment income generally includes interest, dividends and short-term capital gains. From that total you subtract any investment interest you paid.
Say you loan your daughter $100,000 to buy that condo. Her net investment income is $800 this year. No income tax will be imputed. But next year your daughter's net investment income is $1,200. You will have to pay that amount or the AFR rate, whichever is lower.
If the AFR rate is 5%, that would be $5,000 on a $100,000 loan. So $1,200 in imputed income would be taxed to you that year.
The two exceptions described above are only for income tax purposes. Interest-free loans would still have gift tax consequences.
The same is true for below-market loans. If you loan money to your daughter at 2% when the AFR is 5%, the 3% gap will be imputed.
Income tax may be avoided by using either of those two loopholes, but gift tax will apply on the 3% gap.
The annual gift tax exclusion can help you avoid some problems. You can give up to $12,000 a year to each of any number of recipients, without incurring any gift tax. For married couples, the number is $24,000.
Only excess amounts over either annual cap count against the $1 million lifetime exclusion.
To avoid income and gift tax complications, your best strategy may be to charge your relatives the going interest rate and collect it regularly.
"All parties to the loan should sign a written agreement, spelling out terms of the loan," Ellentuck said. And those terms should be followed.
If you do not have a formal loan agreement and no interest has been paid, the IRS may say the transaction was a gift, not a loan. The entire amount could be called a gift, which could trigger a gift tax.
Coping Tactic
One tactic is to call the debt a demand loan rather than a term loan. A demand loan has no specific maturity date. And it is payable in full whenever the lender demands it. Yet a borrower may pay it off early, without a prepayment penalty.
This type of a loan is considered short term by the IRS. Short-term loans usually have lower interest rates than mid- and long-term loans. That may make it easier for your child to make the required payments.
If your child pays a market rate of interest, no income or gift tax will be imputed. You'll have taxable interest income, and your child may get to deduct interest that's paid.
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