September, 2004 Tax Tip
Borrowing From Family Members
When in a financial pinch what better source of obtaining needed funds than by borrowing from parents or other relatives? There are, however, important practical and tax matters that should be considered before making an intrafamily loan.
In many intrafamily loans the lender, while hoping to be repaid, realistically may not expect to be repaid any or part of the loan. This often occurs when parents lend money to their children. Therefore, before making a loan, consider how much you can give without putting your financial future at risk if you are not repaid. There also may be potential gift tax implications if you loan money and do not expect or anticipate its repayment. Therefore, ask yourself whether you truly intend to be making a loan as opposed to making a gift.
If you do decide to lend money to a family member, make the deal as businesslike as possible by putting it in writing. While it may seem overly formal to document a loan to a family member, without a note or other documentation, the IRS could argue that there was no loan at all, but rather a gift. Also, if the borrower is unable to repay all or some of the loan and you want to write it off as a nonbusiness bad debt, documentation of the loan could become very important.
It is quite common for family members to make loans to other family members at either no or below-market interest rates. According to the tax laws, below-market loans are those that have an interest rate lower than the applicable federal rate (AFR) established by the IRS as the minimum for loans between family members. These rates are based on the type and term of the loan and are set monthly.
If the loan is a demand loan (one payable in full at any time on the lender's demand), if the lender does not charge interest at least equal to the AFR, he or she is considered to have received "imputed" interest. This means that the lender is taxed on the amount he or she would have received if the AFR had been used. For gift tax purposes, the lender is treated as if he or she gave the borrower an annual taxable gift of the imputed interest amount.
There are two important exceptions to the imputed interest rules. The below-market imputed interest rules do not apply to individual loans with an aggregate outstanding amount of $10,000 or less on any given day. However, this exception does not apply if the loan proceeds are used to purchase income-producing assets, such as securities.
The second exception is a bit more complex and is broader in its application. For below-market loans up to $100,000 between individuals, the amount of interest added to the lender's taxable income is limited to the borrower's net investment income (investment income less investment expenses). In cases where the borrower's net investment income is less than $1,000, the lender will not be required to include any imputed interest from the loan in his or her taxable income.
For example, if you gave your child an interest-free loan to buy a home or start a business, you wouldn't pay any tax on imputed interest as long as he or she doesn't earn net investment income over $1,000. If your child's investment income exceeds $1,000, the imputed interest income rules apply. The interesting (no pun intended) thing about this is that it is incumbent upon you, the father, to find out from your child the amount of his or her net investment income.
Because of the complexity of the imputed interest rules and their exceptions, it is highly recommended to seek professional advice if you are considering a loan to a family member. As always, I would be happy to assist you in this regard.
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