No law prevents you from loaning money to family-members. But, when you do so, it’s important to exercise caution. Why? Because, apart from the risks involved in mixing family and money lending, you may also have to deal with some surprising tax implications. That’s right! When the IRS rules come into play, what you consider an act of goodwill can turn into a serious nightmare. So if you want to help a family member financially, here’s the right way to do it:
Charge an Interest Rate that’s IRS-Approved
Money lending to family members should be well within the IRS rules concerning interest. Never loan money to a relative at zero interest. To avoid tax complications, charge an interest rate that is at least equal to the IRS-approved AFR.
What are AFRs?
AFRs or Applicable Federal Rates are the minimum interest rates set by the IRS for private loans. These rates are very low and are applicable to term loans. This means that they come with a defined repayment schedule and payment due date. These term loans are classified as short-term, mid-term, and long-term based on the loan period.
Depending on the loan period, the AFR varies. These AFRs are updated on a monthly basis in line with market conditions. The monthly changes in AFR will however not affect the interest rate you fixed for your term loan. It will remain fixed for the entire loan period. However, if you make a demand loan, which can be called anytime, you must charge a floating AFR which will fluctuate according to the market conditions.
So, when you charge an interest in accordance with the IRS rules, you can avoid undesirable tax consequences. All you need to do is simply report the interest you receive as taxable income.
What happens when you charge no interest?
When you make an interest-free loan to a relative, or charge an interest lower that the APR, the below-market interest rules come into play. The IRS rules concerning no-interest loans are complex and counterintuitive. Although you may not be receiving an interest on the loan, the IRS treats the transaction as if the borrower paid you interest as per the APR. What’s more? It also considers that you subsequently gifted the interest back to the borrower.
This may result in two taxable consequences: Firstly, you are taxed on your imaginary or imputed interest income. And secondly, if the amount is high, you will be liable for a gift tax on the imaginary interest that you paid back to the borrower.
Similarly, if you charge an interest rate lower than the APR, the IRS treats the transaction just like a loan with no interest. But the imaginary interest will be equal to the difference between the interest as per APR and the actual interest paid.
But here’s the good news. There are exceptions to these IRS rules governing money lending. If the loan you make to the borrower does not exceed $10,000, you are completely exempt from tax liabilities. And up to this amount your loan can be interest-free. But even then, make sure you put the loan in writing so that the borrower respects it as a deal rather than as a gift!