There are many people who are happy to lend money to their family members, especially to children and grandchildren. But before signing the check or handing over the cash, review the tax rules. The tax consequences can and do vary greatly, depending on the terms of the loan. A small change in the terms of lending can make a large difference in taxes and penalties.
The tax team at Pittsburgh and North Hill's / Wexford most trusted accounting firm can answer any questions you may have regarding family loans. Call us at (412) 931-1617.
Because most family loans are informal agreements, they usually don't carry an interest fee or even a payment schedule. These types of loans are considered below-market. Below-market means a loan that charges no interest or a rate below the applicable federal rate, or AFR. If there is no or below-market interest rate, the interest that isn’t charged is assumed to be income to the person providing the loan from the borrower. In other words, there is imputed interest income or phantom income. The loaner is to report interest income at the IRS-determined minimum rate as gross income, though no cash is received. Essentially, when you make a below-market loan, the IRS treats you as making an imputed gift to the borrower. The imaginary gift equals the difference between the AFR interest you “should have” charged and the interest you actually charged, if any. The borrower is then deemed to pay these phantom dollars back to you as imputed interest income. Although this is all fictional, you must still report the imputed interest as taxable income on your Form 1040. The resulting extra federal income tax implications are NOT fictional. Fortunately, there are two loopholes that can make sure you can still provide a family loan, without all of the tax requirements.
Here is some good information from Bill Bischoff over at MarketWatch.com -
The $10,000 loophole
For small below-market loans, the IRS lets you ignore the imputed gift and imputed interest income rules. To qualify for this loophole, any and all loans between you and the borrower in question must aggregate to $10,000 or less. If you pass this test, you can forget all the nonsense about imputed gifts and d interest. Beware: The $10,000 aggregate loan limit applies to all outstanding loans between you and the borrower, whether or not they charge interest equal to or above the AFR.
Key Point: You cannot take advantage of the $10,000 loophole if the borrower uses the loan proceeds to buy or carry income-producing assets.
The $100,000 loophole
With a larger below-market loan, the $100,000 loophole may save you from tax-related grief. You’re eligible for this loophole as long as the aggregate balance of all outstanding loans (with below-market interest or otherwise) between you and the borrower is $100,000 or less.
Income tax consequences under this loophole: 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. If the borrower’s net investment income exceeds $1,000, your taxable imputed interest income is limited to his or her actual net investment income. The borrower must give you an annual signed statement disclosing his or her net investment income for the year. Keep this document with your tax records.