Lending to Relatives
Today’s low-interest-rate environment
makes it easy to loan money to family members on favorable terms
with full IRS approval. Here’s a rundown of what the law covers and
why now might be a good time to set up loans.
Nothing in the tax law prevents you from making loans to family
members (or unrelated people for that matter). However, unless you
charge what the IRS considers an
“adequate” interest rate,
the so-called below-market loan rules come into play.
For instance, let's say you loan $50,000 interest-free to your
daughter so she can buy her first home. Under the below-market loan
rules, this can have unexpected income tax consequences for both you
and your daughter, as well as gift tax consequences for you. Who
needs the hassle?
The alternative is to charge an interest rate equal to the
"applicable federal rate" (AFR). As long as you do that, the IRS is
satisfied and you don’t have to worry about any tricky tax rules
biting you. As the lender, you simply report as taxable income the
interest you receive. On the other side of the deal, the borrower
may be able to deduct the interest expense on his or her personal
return, depending on how the loan proceeds are used.
Even better, you don’t have to charge much interest these days to
satisfy the IRS. The AFRs for February 2006:
4.30 percent for “short-term” loans of three years
4.31 percent for “mid-term” loans of more than
three years but no more than nine years.
4.52 percent for “long-term” loans more than nine
AFRs are updated each month in response to ever-changing bond
market conditions. So rates may not stay this low forever. As long
as they do, however, the time could be ripe for making favorable
loans to relatives.
if you decide to lend
$50,000 to your daughter, you could charge the mid-term AFR (only
4.31 percent in February) for a 108-month loan (nine years). She can
pay that same low rate for the entire loan term with the
government’s blessing. Say you want to make it a 15-year loan
instead. No problem. Just charge a rate equal to the long-term AFR
(only 4.52 percent in February). Your daughter can pay that same low
rate for the entire 15-year loan term.
is important with family loans. If the person never
pays you back, and you make a good faith attempt to collect,
you'll want to claim a nonbusiness bad debt deduction. These
write-offs are treated as short-term capital
If you don't document your loan and
you're audited, the IRS may say the family loan was a gift and
disallow a bad debt deduction. And there could be problems
because you didn't file a gift tax
However, these rules apply to term loans. When you make
a demand loan, which can be called in anytime, the AFR
isn’t fixed in the month you make the deal. Instead, you must charge
a floating AFR, based on fluctuating short-term AFRs. So if you
believe rates are headed higher in the future, it’s best to set up a
term loan (one with a specific repayment date or specific
installment repayment dates). That locks in today’s low AFR for the
entire duration of the loan.
With this plan, everybody
should be happy. You'll be charging an interest rate the IRS
considers adequate. The borrower should be pleased with the low
rate. And you’re glad to give the borrower some financial assistance
without creating any tax complications.
One more thing: Under a favorable tax law
loophole, you are completely exempt from the below-market loan rules
if the sum total of all loans between you and the borrower adds up
to $10,000 or less. (This includes all outstanding loans to that
person, whether you charge adequate interest or not.) Thanks to this
loophole, interest-free loans of $10,000 or less generally don’t
cause any tax difficulties for either you or the borrower.