Thinking about lending money to family? The IRS has something to say about that.

Yes, even loans between family members are policed by the IRS. The good news: The cost of these loans has fallen sharply this year.

  • By Laura Saunders,
  • The Wall Street Journal
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For families that can afford to, now is a great time to lend money to deserving relatives.

Family members slammed by the coronavirus pandemic may sorely need cash, while others may have it and want to help. But both lenders and borrowers should be aware of strict tax rules governing intrafamily loans.

The good news is that the required interest rates on family loans are at or near historic lows due to turmoil from the pandemic. For such borrowings in May 2020, the Internal Revenue Service mandates a minimum rate on long-term loans (more than nine years) of 1.15%, compared with 2.7% a year ago and 4.38% in 2010.

The IRS’s rate for midterm loans, which run from three to nine years, is 0.58%, and the rate for short-term loans of three years or less is just 0.25%. For loans made now, these are fixed rates that don’t change when rates rise. Lenders are allowed to charge more than the minimum rate.

“I never thought we’d see rates this low, and they may continue for a while because of the crisis,” says Marc Minker, an accountant who advises families on tax strategies at CBIZ MHM in Naples, Fla.

Why does the IRS have any say in family loans? In times when interest rates were higher and the gift-tax exemption far lower than today, people tried to disguise gifts to heirs as loans that charged little or no interest. So Congress had the agency publish monthly interest rates based on Treasury benchmarks that set a boundary between gifts and loans when both parties have an incentive to bend the rules. And Treasury yields lately have fallen to historic lows as investors seek shelter in U.S. government debt.

To be clear, tax specialists say the rules for family loans mainly matter for loans greater than the annual gift-tax exemption of $15,000 for an individual or $30,000 per money-giving couple. Below that, the IRS is unlikely to focus on them—unless the taxpayer tries to take a deduction for a bad debt if the relative doesn’t pay. To get this write-off, even on a small loan, the lender must have charged interest, drawn up paperwork, and made an effort to collect the debt.

With today’s low rates, family members who are able to lend funds to relatives can do so at rock-bottom costs. The borrower avoids higher rates charged by commercial lenders, and the family lender owes lower taxes on the interest payments.

The current low rates often provide the best opportunities for very rich families to pass wealth to the next generation. Those with assets greater than the combined federal gift- and estate-tax exemption of $11.58 million per individual, or $23.16 million per couple, can minimize gift or estate taxes with strategies using such loans.

But advisers say families with assets below the exemption are using loans as well. Often, they help a younger family member buy a house with cash or reduce the cost of student-loan debt, especially for a professional degree. Sometimes they help fund a business, buy a car or pay off credit-card debt. They can also be used to help nonrelatives.

What these loans often cannot do is fund a down payment on a home, due to bank rules. Mortgage bankers typically allow gifts to provide a down payment—but not loans.

Some families may now want to make gifts to relatives rather than loans because the high gift- and estate-tax exemption is set to drop sharply in 2026. But making a loan can be more prudent than making a gift.

For example, say that a couple wants to help their daughter and her husband buy a house. Providing a family loan to the couple rather than giving them the purchase price means that if the couple splits, they’ll be dividing a debt rather than an asset. If the lenders want to be generous, they can use the annual gift-tax exemption of $30,000 a year to forgive portions of the loan.

Family loans do come with a giant caveat: the potential emotional complications. If one relative gets a loan, what about others? What will happen to relationships if the borrower defaults? Will someone who has racked up huge credit-card bills be more responsible with a family loan?

“You don’t want family gatherings to be awkward. It especially bothers siblings when the borrower isn’t making payments but seems to be spending frivolously,” says Ann Reilley Gugle, an adviser with Alpha Financial Advisors in Charlotte, N.C.

For families that can navigate these titanic interpersonal issues, here’s more guidance on legal details.

Make it fully legal. To avoid trouble with the IRS, says Mr. Minker, total loans above the gift-tax exemption of $15,000 or $30,000 a year should be fully documented and state the rate, term, repayment schedule and default clauses, among other things.

The loan should be signed by all parties and notarized. For a loan used to buy a home, the lender should consider filing a lien to make the loan official in case of default. These tasks will likely require some but not a lot of professional help, he adds.

Consider credit effects. Borrowers who get family loans don’t need to worry about rough credit or lumpy incomes. But timely repayment probably won’t help build credit, either.

Streamline paperwork. Advisers suggest setting up systems to provide for automatic withdrawals and deposits between borrowers and lenders and to keep records for taxes.

The administration of family loans can be outsourced, either to a local financial adviser or to a national firm such as NationalFamilyMortgage.com.

Follow through. The lender owes tax on interest payments. If proper procedures are followed, the home buyer will be eligible for a mortgage-interest deduction—although fewer benefit from this write-off given the 2017 tax overhaul’s increase in the standard deduction.

If the borrower defaults on the loan, the lender may be eligible for a bad-debt deduction at tax time. It counts as a short-term capital loss and can offset capital gains, as well as up to $3,000 of ordinary income. Unused losses carry over.

Don’t forget estate planning. Lenders should leave instructions, either with an executor or in the will itself, about how to deal with outstanding loans at death. If they forgive the loans, they may want to equalize the borrower’s treatment with other heirs.

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