Tax Implications for Family Loans

Family loans are still treated as loans when it comes to filing taxes. This can be confusing for an individual who thinks a loan from mom or dad is not of concern to the IRS. However, the IRS is very aware of the way loans and gifts between family members can be used to avoid taxes. As a result, these loans and gifts are subject to explicit tax rules that must be followed.

You Must Charge Interest

If you do not charge interest on a loan to a family member, it is considered a gift. You, the donor, are responsible for paying a gift tax in this case. Further, the annual amount you can gift is limited. As a result, if you are extending a loan not a gift, it is wise to charge interest equal to or exceeding the applicable federal rate (AFR). You can find the AFR on the IRS website, and the exact AFR in any situation will depend on the length of the loan; short term loans last three years or less, mid-term loans last between three and nine years, and long term loans last more than nine years. The applicable rate will depend on the length of the loan because it is set based on Treasury bond rates.

The Receiver May Deduct Interest

While the individual receiving a loan must pay interest, they may be able to deduct that amount from federal income taxes. The amount the receiver can deduct depends on how the loan is used. For example, if the loan is used to repay other debts, the deductible amount is equal to non-deductible personal interest on the other loan. If the loan is used to build, improve or otherwise fund a business, the interest is a deductible business expense. If the loan is used to purchase an investment asset, the interest rules applying to that particular investment must be followed. Finally, if the loan serves as a mortgage, the individual can deduct the interest just like mortgage interest.

Exceptions

There are a few exceptions to the IRS family loan rules. Most importantly, the IRS does not regulate loans of $10,000 or less, as long as the loan is not used to generate income in any way. This can be a tricky rule to follow. For example, if you loan your son or daughter money to purchase a car, you may think there is no investment income to report. However, if the car is sold in the future, and the proceeds are used to purchase stock, the loan has generated income for your son or daughter. As a result, it would be against IRS regulations not to report the loan. The borrower would have an initial cost basis on the car loan that would transfer over to the investment in stock. When you are unsure whether the $10,000 exception applies, report the loan to your tax adviser. A Certified Public Accountant will be able to inform you of the nuances of the family gift laws.

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