Interest--How to Set Up A Bargain-Rate Family Loan
If you want to lend money to a family member, you may think that the way you set up the loan is no one else's business -- certainly not the IRS's. However, there may be tax ramifications to a family loan if you charge less than the going rate of interest for similar loans, or if you charge no interest at all. That's because you're treated as having made a gift to the borrower equal to the foregone interest (the interest you could have charged less the interest you actually charged, if any).
The worst-case scenario is an absolute disaster: If none of the exceptions applies, the tax law transforms the low- or no-interest family loan into the following series of events:
lYou as lender are treated as having charged the full market interest rate on the loan,
lThe family member who borrows from you is treated as having actually paid you market interest, and
lYou are considered to have made a gift to the borrower equal to the foregone interest.
As a result, you must pay income tax on phantom interest income. You also are treated as having made a gift equal to the foregone interest. If your annual gifts to the borrower (including the foregone interest) don't exceed $10,000 ($20,000 if your spouse consents to join in the gift), however, there are no gift tax consequences.
Fortunately, you can completely avoid these tax problems if the principal balance of all of your loans (below-market rate or not) to the family-member borrower does not exceed $10,000. But this $10,000 exception does not apply to a below-market family loan if it is attributable to the purchase or carrying of income-producing assets. In other words, if you make a zero-interest loan to your son to enable him to buy an investment, the break does not apply.
In addition, special and on the whole very liberal rules apply to a below-market-interest family loan that doesn't exceed $100,000, as long as tax avoidance isn't one of the principal purposes of making the below-market loan. The amount of phantom interest income you're considered to have earned on the loan can't exceed the family-member borrower's net investment income. And if his or her net investment income doesn't exceed $1,000, you are not taxed on any phantom income at all. However, even though you avoid being taxed on phantom income, you are still treated as having made a gift of the foregone interest. The gift nonetheless can be sheltered from gift tax by the annual $10,000 per-donee gift-tax exclusion ($20,000, if the spouse consents to the gift), if you set the loan up in the right way. The best way to do that is to make the loan payable on demand. If you use a term loan (e.g., a loan payable over a set term of ten years), the amount of the gift takes into account the foregone interest over the life of the loan and could result in a gift in excess of the annual gift-tax exclusion.
We don't want to discourage you from making a bargain-rate loan to a family member -- if that is what you want to do. We do want to steer you clear of a minefield of tax complications. Please call our offices and we'll help you set up the loan in the right way.