Suppose Hi Profits, son of Max and Rosie Profits, wants to buy a house and needs help with the down payment. Max and Rosie lend $100,000. They charge 3.22% interest on the loan, which in July 2019 was the applicable federal rate for a long-term loan where interest is compounded semi-annually. Need help deciding whether to give or lend money to a family member? Call 800-355-2162 to speak with a Schwab investment professional. The loan must be legal and enforceable. Otherwise, it can be considered a gift. At present, RFAs are still very low by historical standards. Therefore, it makes sense to take out a loan that charges the AFR instead of a lower interest rate or an interest rate of 0%. Reason: You can give the borrower (your relative or friend) a transaction of sweet interest without causing tax complications for yourself. Max and Rosie have two costs for the loan. The first costs are the investment income they could have earned from the $100,000. In case of need, the family appears.
That`s exactly what you`re doing. But beware: while lending money to the family may seem like a good idea, a family loan, if not executed properly, can result in unexpected taxable income, gift tax, or both. So, which method is right for your family and under what circumstances? Start by considering the following points. You grant your beloved nephew a five-year loan in May 2019 and charge an interest rate of exactly 2.35% with monthly compound interest (the AFR for medium-term loans granted in May). You have taxable interest income based on this rate for the term of the loan. Your nephew has an equal amount of interest expenses – which may or may not be deductible depending on how the loan proceeds are used. From a tax perspective, that`s all you need to know about the interest issue. So if you decide to calculate the AFR, you can ignore most of the rest of this column. However, if you insist on charging less than the AFR, you need to read the whole thing. Sorry. There are a few exceptions when the AFR does not need to be calculated for a loan.
First, if all loans between these two individuals do not exceed $10,000 and the loan is not directly attributable to the purchase or transfer of an income-generating asset, the interest rate may be below market and no imputed interest should be calculated. If, at any given time, the total loans to that person exceed $10,000, this exemption does not apply and the loan continues to be subject to gift and income tax, regardless of the amount of capital remaining. There is also the issue of crime to consider. If a family member can`t repay a loan, the lender rarely reports it to a credit bureau, let alone a collection agency. However, if the lender wishes to deduct a non-performing loan from its taxes, the IRS will require proof of an attempt to recover the overdue funds. Borrowing money from the family can be a tricky issue. If you`re thinking about how to financially help a family member, talk to your Cree advisor first. We are always here to help. The second exception applies to loans of $100,000 or less. The imputed income rules apply, but the lending parent or grandparent may report interest charged at the lower value of the applicable federal interest rate or the borrower`s net investment income for the year. If the borrower does not have much investment income, the exception can significantly reduce the amount of imputed income reported. For income tax purposes, term loans are treated in essentially the same way as demand loans.
But the consequences of the donation tax are very different. If you make a loan to a family member below market value, your donation will be equal to the amount of the loan exceeding the present value of all future loan payments (using the AFR as the discount rate). If you choose to give a low-interest or interest-free loan to a family member, try to avoid a term loan so as not to make a large initial donation. Document everything. Basically, you need to be able to prove that you intend to view the money as a loan and not as a gift. Make your intentions clear – and help avoid credit misunderstandings – by recording loan payments received. Also, be sure to keep the following in mind: The alternative is to charge an interest rate equal to the “applicable federal rate” (AFR). As long as you do that, the IRS is satisfied and you don`t have to worry about tricky tax rules biting you. As a lender, you simply report as taxable income the interest you receive. On the other side of the business, the borrower may be able to deduct interest expenses from their personal performance, depending on how the loan proceeds are used. Documentation is important for family loans. If the person never reimburses you and you try to collect in good faith, you should claim a deduction for non-commercial bad debts.
These depreciations are treated as short-term capital losses. * The AFR for a long-term loan – more than 9 years – is only 2.70%. Today`s low interest rate environment makes it easy to lend money to family members on favorable terms with full IRS approval. Here`s a look at what the law covers and why it may be the right time to set up loans. You may want to help a young family member buy a first home or help a financially disadvantaged relative or friend by lending money to that person. Nice thought, but if you get away with it, please make it a tax-smart loan. This column explains how to avoid adverse tax consequences if you give a personal loan to a relative or friend. A written loan agreement can also avoid misunderstandings between the borrower and your estate or other family members after you leave.
Your will should indicate whether you want the loan on your estate to be repaid, cancelled and deducted from the borrower`s heir or otherwise processed. As you can see, these ABFs are much lower than the interest rates charged by commercial lenders. However, as long as you charge at least the AFR for a loan to a family member or friend, you don`t have to worry about the tax complications discussed later in this column. You can give your children “student loans” by establishing a contract like any other loan. Whatever the reason you`re lending money to a family member, make sure you understand the IRS rules for family loans. Working with your team of wealth management advisors to ensure that your loan does not entail income tax obligations and donations will result in a positive outcome for you and your loved ones. The interest rate on the loan must be at least as high as the minimum interest rates set by the IRS. If you don`t document and verify your loan, the IRS may say the family loan was a gift and won`t allow a deduction of bad debts. And there could be problems because you haven`t filed a tax return on donations. One last thing: under a favorable tax loophole, you are completely exempt from the below-market credit rules if the sum of all loans between you and the borrower is $10,000 or less. (This includes all outstanding loans to that person, whether or not you charge reasonable interest.) Thanks to this loophole, interest-free loans of $10,000 or less usually don`t cause tax problems for you or the borrower. If you don`t, the IRS may say that the interest you should have charged was a gift.
In this case, the interest money will be paid within your annual donation limit of $14,000 per person. If you give someone more than $14,000, you will need to file a donation tax form. For term loans (those with specific repayment dates), the relevant AFR is the interest rate that applies to loans of that term for the month in which you take out the loan. . . .