You may want to help a young family member buy a first home or help a financially challenged relative or friend by loaning that person some money. Nice thought, but if you follow through, please make it a tax-smart loan. This column explains how to avoid adverse tax consequences when you make a personal loan to a relative or friend.
The interest rate issue
Most loans to family members or friends are below-market loans in tax lingo. Below-market means a loan that charges no interest or a rate below the applicable federal rate, or AFR.
AFRs are the minimum interest rates you can charge without creating unwanted tax side effects for yourself. AFRs are set by the government, and they can potentially change every month.
Right now AFRs are still very low by historical standards. So making a loan that charges the AFR instead of a lower rate or a 0% rate makes good sense. Reason: you can give the borrower (your relative or friend) a sweet interest rate deal without causing tax complications for yourself.
Rates for term loans
For term loans (those with specified repayment dates), the relevant AFR is the rate in effect for loans of that duration for the month you make the loan. Here are the AFRs for term loans made in May of this year.
- For a short-term loan — one with a term of 3 years or less — made that month, the AFR is 2.37%, assuming monthly compounding.
- The AFR for a mid-term loan — over 3 years but not more than 9 years — is only 2.35%. Yes, that’s lower than the short-term rate. Go figure.
- The AFR for a long-term loan — more than 9 years — is only 2.70%.
The same AFR continues to apply over the life of the term loan, regardless of how interest rates may fluctuate.
As you can see, these AFRs are much lower than rates charged by commercial lenders. However as long as you charge at least the AFR on a loan to a family member or friend, you don’t have to worry about any of the tax complications explained later in this column.
You make a five-year term loan to your beloved nephew in May of 2019 and charge an interest rate of exactly 2.35% with monthly compounding (the AFR for mid-term loans made during May). You’ll have taxable interest income based on that rate for the life of the loan. Your nephew will have an equal amount of interest expense — which may or may not be deductible depending on how the loan proceeds are used. Tax-wise, that’s all you need to know about the interest rate issue. So if you decide to charge the AFR, you can ignore most of the rest of this column. However if you insist on charging less than the AFR, you’ll have to read the whole thing. Sorry.
Rates for demand loans
If you make a demand loan (one that you can call due at any time) instead of a term loan, the AFR for each year will be a blended rate that reflects monthly changes in the short-term rate. So with a demand loan, the annual blended AFR can change dramatically depending on how general interest rates move. This creates uncertainty that both you and the borrower would probably prefer to avoid. In contrast, making a term loan that charges the current AFR avoids any interest-rate uncertainty, because the same AFR will apply for the entire life of the loan.
Warning: Get your loan in writing
Regardless of the interest rate you intend to charge (if any), you want to be able to prove that you intended the transaction to be a loan rather than an outright gift. That way if the loan goes bad, you can claim a non-business bad debt deduction on your Form 1040 for the year you get the bad news.
Losses from non-business bad debts are classified as short-term capital losses. Capital losses are valuable because they can offset capital gains and potentially up to $3,000 of income from other sources, or up to $1,500 if you use married filing separate status. Any remaining net capital loss gets carried forward to next year and will be subject to the same rules next year.
Without a written document, your intended loan will probably be characterized as a gift by the IRS if you get audited. Then if the loan goes bad, you won’t be able to claim any non-business bad debt loss deduction. In fact, you won’t be able to deduct anything, because ill-advised “gifts” do not result in deductible losses. To avoid this problem, your loan should be evidenced by a written promissory note that includes the following details:
- The interest rate, if any.
- A schedule showing dates and amounts for interest and principal payments.
- The security or collateral for the loan, if any.
Make sure the borrower signs the note. If your relative or friend will be using the loan proceeds to buy a home and you are charging interest, be sure to have the note legally secured by the residence. Otherwise the borrower can’t deduct the interest as qualified home mortgage interest.
At the time you make the loan, it’s also a good idea to write a memo to your tax file documenting reasons why it seemed reasonable to think you would be repaid. This supports your contention that the transaction was always intended to be a loan rather than an outright gift.
Tax rules for below-market loans
As I just explained, the tax results are straightforward if your loan will charge an interest rate that equals or exceeds the AFR. But if you insist on charging less or nothing, you’ll have to finesse the tax rules in order to avoid unpleasant surprises. Here’s what you need to know.
When you make a below-market loan (one that charges an interest rate below the AFR) to a relative or friend, our beloved Internal Revenue Code 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 hit is not fictional. Fortunately, you can usually dodge this problem via the following two loopholes.
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.
You make a $100,000 interest-free loan to your beloved niece who has $200 of net investment income for the year. Your taxable imputed interest income is zero. However if your niece’s net investment income is $1,200, your imputed interest income is $1,200. In most cases, the borrower will have under $1,000 of net investment income. If so, you’ll have zero imputed interest income under the tax rules. Good!
Gift tax consequences under this loophole: The gift tax results under the $100,000 loophole are tricky, but they will almost never have any meaningful impact under the current federal gift and estate tax regime. Reason: the unified federal gift and estate tax exemption for 2019 is $11.4 million, and the exemption is scheduled be even bigger next year thanks to an inflation adjustment. Such ultra-generous exemptions mean almost a zero percent chance of any negative gift tax consequences from making a below-market loan. But if the Sanders-Warren ticket wins in 2020, you might want to check back with me for an update.
The bottom line
As you can see, there are potential tax complications when you are nice enough to make a loan to a family member or friend. But you can avoid the pitfalls by planning and documenting your loan transaction as I’ve advised here. You’re welcome.
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