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Guide to Short Term Savings | Budgeting
101 | Getting Out of Dept | How
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What you need to know before you write
By Roy Lewis (TMF Taxes) August
If your family is like many, it's just
a matter of time before somebody near and dear to you hits
you up for a loan. This doesn't necessarily have to be a
bad deal. You can help a family member with the capital to
start a business, make an investment, pay personal expenses,
or even buy a home. And, the interest stays in the family,
rather than going to some cold, impersonal bank or finance
company. So, if done correctly, it can very well be a "win-win" situation.
However, if you decide to make the loan, there are some
issues that you should understand relative to family loans
and taxes. As with any loan, a loan to a family member should
be made in a businesslike manner. You should make sure that
you create an enforceable note that shows:
- The loan amount
- A definite payment date or dates
- A stated rate of interest
- Collateral or security
Without a valid note, the IRS could make a claim that there
was really no loan at all... that the money was nothing more
than a gift. If you are making the loan, this is the last
thing that you want. And, that is especially true if the
loan goes bad some time in the future.
As the lender, you are required to report the interest you receive on
the note as income. Simple as that. You'll report your interest income
on Schedule B.
But the borrower's rules are not so clear-cut. How the money
is used will determine if the interest paid is deductible
or not. For example:
If the loan goes toward paying personal debts and obligations,
the interest paid on the loan will be nothing more than
non-deductible personal interest. If the money is used
for business purposes, the interest paid will likely be
a business expense, deductible on the appropriate business
If the proceeds were used to purchase investments, then the interest
would likely be considered investment interest, subject to the investment
If the loan is used to purchase or refinance a primary or second residence,
it is quite possible that the interest would be considered deductible
home mortgage interest (assuming that the property is secured by the
note in the form of a mortgage or trust deed).
So, the interest rules can get quite complex for the borrower.
If you are the borrower, make sure you know how the rules
will work for (or against) you.
Interest on loans between related parties
As a lender, it is usually best to charge the family member interest
at the going rate. Why?
Because, as we noted, an interest-free loan could be viewed by the IRS
as nothing more than a gift. Not only that, the IRS might deem that you
actually did receive the going rate of interest, and gave that interest
back to the family member. So, even if you don't charge or collect interest
on the family loan, the IRS can step in and make you report interest
income that you never received. It is best for all concerned to simply
charge interest on the note at a reasonable and normal rate.
But in many cases, related individuals make loans for less
than the normal going rate. That's not unusual at all. The
IRS understands that fact of life, which is why it has established
minimum loan rates for loans between related parties. These
rates (known as the Applicable Federal Rates, or AFR in tax-speak)
change on a monthly basis, and are basically tied to the
yield on Treasury securities. The AFR is determined by the
length of the loan being made as follows:
- Short-term (three years or less)
- Mid-term (more than three years but not more than nine
- Long-term (more than nine years)
The AFRs have been hovering above 5% for long-term loans.
The IRS publishes applicable federal rates each month in
the Internal Revenue Bulletin that you can find at the IRS
website. Or, for another option, you can find the current
AFR by pointing your Web browser to http://evans-legal.com/dan/afr.html.
Awwwww... come on, Mom!
You explain to your child why you need to charge interest and that is
exactly what you hear in a loud and pitiful high-pitched voice. What's
a mother to do? If you decide not to charge the AFR on the loan, you
may run afoul of the below-market loan rules. You likely don't want
to do that. But, fear not! As usual, there are exceptions to the below-market
The first exception is known as the $10,000 exception. The
rules for below-market loans do not apply to loans of $10,000
or less, and to loans for which the proceeds are not directly
used to buy income-producing assets (such as stocks or bonds).
So that clears the way for you make a loan to a family member
for $10,000 or less and not charge interest, as long as the
proceeds are not used to purchase stocks, bonds, notes, or
other income-producing property.
The second exception is (as usual) a bit more complicated.
It's known as the $100,000 exception. That exception simply
states that the loan must be for $100,000 or less, and the
borrower's net investment income (loosely defined as interest,
dividends, and short-term capital gains, less any investment
expense) cannot exceed $1,000. If the borrower's net investment
income exceeds $1,000, the lender will be required to report
interest income in an amount equal to the net investment
income of the borrower.
Example: Marilyn makes a loan to her daughter Jill so she
can start a business. Let's assume that, using the AFR, the
annual interest would amount to $3,500. But Marilyn decides
to simply forego this yearly interest to help Jill with her
tight money problems. So far, so good. There are no gift
tax implications to Marilyn because the foregone interest
is less than the $11,000 annual gift tax exclusion. As long
as Jill has net investment income of $1,000 or less, Marilyn
will not have any interest income to report. Likewise, since
the interest isn't paid, Jill has no interest expense to
But let's change the picture a little bit. Let's say that
Jill's net investment income amounts to $2,000. In this case,
because Jill's net investment income is greater than $1,000,
Marilyn will be required to report $2,000 as interest income,
and Jill will have an interest deduction for $2,000.
The below-market rules can get a little tricky, so if you
are contemplating making a loan to family members or any
other related party (such as employee-employer, an individual
to his or her corporation or partnership, and many others),
make sure that you have a firm grip on the rules. You can
read much more about related-party transactions and the below-market
interest rules in IRS Publication 550 at the IRS website.