Lending to family members probably dates back to the invention of money. The IRS entered the mix a great deal later, but it now looms large in the equation. Tax problems can arise when you first lend money, as you’re being repaid, or if you’re not repaid. The issues usually involve imputed income, gift tax, or bad debts.
- Imputed income. Imputed income is revenue presumed earned but neither recognized nor received by the alleged recipient. The IRS may impute interest on a loan at the “applicable federal rate” (AFR) when a lower rate (or no interest) is charged. The agency then assesses tax on the excess of the imputed interest over the amount required by the terms of the loan.
- Gift tax issue. When the IRS imputes phantom interest, it also creates phantom taxable gifts. The imputed interest is treated as though the borrower actually paid it to the lender, whereupon the lender returned it to the borrower as a gift. Since the lender “constructively received” the additional interest, he or she owes income tax on it. Since the lender then presumably gave the interest back to the borrower, he or she also owes gift tax on it, unless an exclusion or credit applies.
- Bad debt deduction. Normally, a loan that goes bad is deductible, either against ordinary income (if made for a business purpose) or as a short-term capital loss. However, when the defaulting party is related, the IRS may demand clear and convincing evidence that the original loan was not actually a gift. Once a loan is recharacterized as a gift, no bad debt deduction will be allowed if the loan isn’t repaid, and the lender also may owe gift tax on the principal unless an exclusion or credit applies.
Interest need not be charged and will not be imputed on a family loan of $10,000 or less unless the loan directly relates to purchasing or carrying income-producing assets. Without a written document imposing interest at the applicable federal rate (AFR) or higher, the loan probably will be considered a gift and thus will not be deductible if not repaid.
Interest will be imputed on a family loan over $10,000 if the stated rate is below the AFR. However, unless the principal exceeds $100,000, imputed interest will be limited to the borrower’s annual net investment income, and no interest will be imputed if that income is $1,000 or less.
Obviously, lending to relatives can create unintended tax consequences. You should always have a written loan agreement on family loans to document the transaction for the IRS. Please contact us for guidance before you make any family loans.