People lend money to family members for a variety of reasons. For example, lending your son money to buy his first home, or lending your daughter money to start a new business. At some point, you may find yourself in a similar situation. Therefore, it is important to know how this will impact you from a tax standpoint.
Are you charging the borrower interest on the loan? If so, you must pay income tax on the interest you collect.
If you lend money, despite the fact that a family member is the recipient, the IRS expects you will charge interest, just the same as a bank would. With this in mind, the IRS has set the “Applicable Federal Rate” (or “AFR”), which varies based on the month of the loan as well as the term. A list of Applicable Federal Rates, by the month, can be found by visiting the IRS website.
In the event that you do not charge interest, it is considered a “gift loan” by the IRS, meaning that special rules apply.
Any loan between individuals less than $10,000 is disregarded. If you charge interest less than the Applicable Federal Rate for a loan between $10,000 and $100,000, the difference is considered a gift for which you may have to pay a gift tax if your total gift tax for the year exceeds 14,000.
What if the loan is in excess of $100,000? Not only is the forgone interest considered a gift, but the IRS automatically assumes that the forgone interest was paid to you as interest, meaning that you have to pay income tax on the money.
Say for instance you lend your daughter $200,000 in a five-year interest-free loan with an Applicable Federal Rate of 2.85 percent, the IRS will assume that you received interest of $5,700 each year. Subsequently, you must pay income tax on that amount each year. For someone with a combined 40 percent federal and state income tax rate, the end result would be $2,280 in additional tax each year.
There are ways around this, such as an Irrevocable Trust. You could set up the Trust so the transactions between you and your Trust are not considered income. For this reason, if you lent $200,000 to the Trust, the IRS would ignore the forgone interest when calculating your tax liability. The forgone interest may still be considered a gift, but the Trust can be designed so that the gift to the Trust will be considered a gift to your family member. The annual gift tax exclusion for 2014 is set at $14,000.
Thinking of loaning someone money? Be sure to consult with a qualified estate planning attorney to ensure that your loans are structured in a manner that will not generate additional income taxation.