Lending to relatives can cause tense situations at family gatherings! While such loans could be a win-win, you need to understand the potential ramifications before you make a commitment. You may solve your grandson’s financial problem, but create a tax issue for yourself.
Parents and grandparents are finding themselves acting as bankers for their children and grandchildren for everything from college to mortgages. Many times this is out of necessity if the younger generation has credit blemishes to overcome or a lack of funds to use as a down payment with a traditional lender.
But wait! Given today’s low interest rate environment, the senior generation is finding that lending to family can provide a better return than investing in certificates of deposit. This can lead to a win-win situation. However, while family loans can provide benefits for both generations, there are some details that should not be overlooked.
Have Your Own Financial House in Order
Before making a loan to a family member, be sure to review your own financial situation to ensure that you can make the loan without jeopardizing your own future. Whether it is a short-term car loan or a long-term mortgage, you as the lender must consider the impact on your situation if the money is never paid back. If you are comfortable that you can live without the funds, then you can enter into the transaction with little concern. However, if this is not the case, then you should think long and hard before agreeing to make the loan.
Make it Formal
It is important that you formally document the loan. Create a promissory note that indicates the amount and the terms of the loan. The terms should include the length of the loan, the interest rate being charged and the payment frequency.
Determining the Loan Interest Rate
The Internal Revenue Service (IRS) provides guidance regarding the minimum interest rate that must be charged to avoid the recognition of a gift between the lender and the borrower. The Applicable Federal Rate (AFR) is published each month by the IRS. The AFR is based on the rates of various U.S. Treasury securities during the previous month. The AFR is generally less than the interest rate charged for either commercial or retail loans. Therefore, an intra-family loan can provide a nice financial benefit for the borrower.
There are different rates provided based on the length of the loan. The short-term rate should be used for loans that are due in less than three years; the long-term rate for loans extending beyond nine years; and the mid-term rate is for everything in between. The AFRs for annual compounding for the month of October 2016 are: .66% (short-term); 1.29% (mid-term); 1.95% (long-term).
As long as the lending rate for your intra-family loan is greater that the AFR for the origination month of the loan, there is no gift created. If the loan is interest-free or has an interest rate less than required, you are deemed to have made a gift to the borrower.
For example, let’s assume that Jane makes a loan to her grandson, Chip, for $10,000 for four years at a rate of 2% in October 2016. Since the rate is greater than the published mid-term AFR of 1.29%, there is no gift consideration. However, if Chip does not make the payments as required, the interest not paid is assumed to have been a gift from Jane to Chip. In addition, the interest, even though not received, would be taxable to Jane.
In 1984, the IRS enacted stricter requirements on the recognition of loan interest payments for tax purposes. In a gift-loan situation for both demand notes and term notes, the low or no-interest aspect of the loan is re-characterized annually as two transactions: 1. The lender is deemed to have made a gift to the borrower of the funds with which to pay some or all of the interest on the loan, and 2. The borrower pays the lender interest in the same amount which is taxable income to the lender and an expense for the borrower.
Interest is always assumed to be taxable income to the lender and must be recognized on the lender’s tax return each year. However, if the loan is a mortgage, in order for the borrower to deduct the interest expense on their tax return, the loan must be secured by the house. In addition, to get the mortgage exemption on property tax, the mortgage loan must also be filed appropriately with the county.
Providing loans to the younger generation can help them weather a difficult economy or simply begin to build wealth more quickly. However, such a loan is not without risk. Be sure to carefully review your own situation and work with a qualified advisor to be sure all the details are in place before anyone signs on the dotted line.
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