There are two main ways to give significant amounts of money to a family member: gifts and loans. Each has its own tax consequences and advantages. In the case of a loan, if you want this not to count as a gift you have to actually structure the transaction as a loan. If you don’t have a written contract with fixed repayments and a minimum interest rate, the IRS will likely treat this as a gift. If you do meet those standards, the loan will typically have few tax consequences. You can work with a financial advisor whenever you’re considering a big financial move like this, though, to see how it might impact your long-term financial plans.
What Is a Family Loan?
Most of the time a simple loan doesn’t rise to the level of tax concerns. Lending someone, say, $20 has no practical tax consequences. To be very clear, the IRS requires you to self-report any and all taxable transactions. However, the tax agency also has what it considers “de minimis” transactions, meaning transactions that are small enough to ignore without triggering tax consequences.
At small enough levels, giving and lending money does not trigger a tax event. The tax agency pays attention when you loan someone the down payment on a house, not when you spot them a couple of beers.
In terms of structure, family loans tend to be informal. Most family members loan money to each other with an ad hoc repayment scheme, then ask for that money back depending on the circumstances. This structure is known as a “demand note,” meaning that the lender can demand repayment back either at will or under certain conditions.
It’s relatively rare for family members to extend a formal loan with written terms and a payment plan. This is a problem, however, because that can trigger real tax consequences.
Family Loans Can Be Taxable Gifts
The big issue when it comes to family loans is determining whether this counts as a loan or a gift. If the IRS considers this transaction a gift, the lender has to report it under the gift tax rules and it will apply to their annual and lifetime exemptions as appropriate. If the IRS considers this transaction a qualifying loan, then it will typically have few (if any) tax implications. It doesn’t count as income for the borrower, because they will pay this money back, nor does the loan count as a gift for the lender for the same reasons.
To qualify as a family loan, the transaction generally has to meet three criteria. You must have:
- A written or otherwise provable agreement between the parties
- A defined repayment schedule
- A minimum amount of interest
Without all three of these criteria, the IRS is very likely to consider your loan some form of a gift. Here are the reasons behind the IRS’ consideration:
1. Written Agreements Prove the Terms of a Loan
First, the IRS always wants to see proof of any tax claims that you make. If you tell the tax agency that this is a qualifying loan, it will want to see proof of a repayment schedule and an interest rate. Showing a history of repayment transactions may be enough to satisfy the IRS, but in most cases, they will want to see a written agreement defining these terms. Without that contract, the IRS is likely to consider this transaction so informal that it does not qualify as a loan.
2. Repayment Schedules Define Nonpayment
Second, without a fixed repayment schedule, there’s no way to tell the difference between when someone has defaulted on their loan and when you have gifted them the balance. This is critical because once someone defaults on a loan several tax implications apply. You can choose to forgive the loan as a one-time gift, at which point you must report that gift on your taxes. You could also forgive the loan and write it off as a loss on your taxes, at which point the recipient may have to claim the amount forgiven as taxable income.
What the IRS does not allow is for you to leave the loan indefinitely unpaid. At a certain point, an unpaid loan becomes a gift. The IRS requires a fixed repayment schedule so that you and more importantly they can tell the difference.
3. Interest Can Be a Gift as Well
Finally, the IRS requires you to charge a minimum interest rate.
Unlike the first two conditions, giving someone an interest-free loan does not automatically turn the transaction into a gift. As long as you have written terms and a fixed repayment plan this will still count as a loan. However, if you don’t charge a minimum amount of interest the IRS will consider that uncharged interest effectively a gift to the borrower. They would have paid interest to another lender, so by not charging anything you have effectively gifted them the interest they would have paid.
The IRS publishes what is called the Applicable Federal Rates (AFRs). This is the minimum amount of interest you can charge and have the entire transaction still count as a loan. If you charge less than an AFR-approved minimum, the IRS considers the difference a gift. You have to report the total amount of uncharged interest on your taxes and it will count against your annual and/or lifetime gift exclusions as appropriate.
Remember the interest that you do charge counts as taxable income that you must report on your income taxes. Now, to be clear, this is often more an issue of paperwork than finances. The AFR rates are low compared with market interest rates. So unless you have extended a very large loan, it’s likely that any amount of unpaid interest will be less than your annual gift exclusion. However, you do have to report it.
The IRS Gives a De Minimis Exception Under $10,000 and $100,000
You do have to report the money unless the loan is small enough to trigger one of the exceptions. The IRS gives two de minimis exceptions for interest on family loans, which are:
The $10,000 De Minimis Exception
The IRS does not require you to charge interest for loans under $10,000. You can extend a loan of that size interest-free with no tax consequences as long as the loan wasn’t used to purchase income-generating assets.
For example, if someone borrows $10,000 to help with the down payment on a home, you don’t have to charge interest. If they use that money toward the down payment on a property they rent out, you do have to charge interest.
Like gifts, loan rules apply to the sum of all lending over the course of a year. So if at any time, the borrower owes you more than $10,000, this exception will no longer apply and you must begin charging interest or reporting it as a gift.
The $100,000 De Minimis Exception
If the total sum of lending is less than $100,000, the IRS allows you to charge interest based on the lesser of either the AFR rate or the borrower’s net investment income for the year. If their investment income was $1,000 or less, the IRS allows them to charge no interest.
For example, say a family member borrows $100,000 from you. At the time of writing a long-term AFR might require you to charge them at least $3,840 per year of interest. However, say they had $1,500 in total investment income for the year. You can use that investment income to define the interest on their loan, reducing it to $1,500 for the year. If they had $900 of investment income for the year, you could charge them no interest at all without triggering gift tax consequences.
The Bottom Line
Family loans are when you make a loan to a friend or family member. If you don’t structure this as a formal loan, the IRS will treat it as a form of a gift. If you do structure it as a formal loan, you have to make sure to account for interest and meet the required criteria so that you don’t get taxed for the money as a gift, especially if you’re paying interest on the money as that could become a very expensive loan.
Tips for Tax Planning
- Before taking money from a family member, or any other source, you may want to first consult with your financial advisor to see how it might impact your finances. If you dont’ have a financial advisor, finding one doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- This article discusses what to do if you don’t want your loan to count as a gift. But what if you do? In that case, it’s worth reading up on how to minimize the tax consequences of making large gifts.
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