Tax Implications Of A Family Loan
According to the Federal Reserve Board Survey of Consumer Finances, loans from family and friends amount to $89 billion each year in the United States. The most popular reasons for asking family members or friends for a loan are to start a business or purchase a home. A national survey by Fundable said that 38% of startup businesses relied on money from family or friends. The National Association of Realtor said that 6% of first-time home buyers used money from family, mostly parents, to buy a house.
Dealing with the IRS is one of the critical, but often overlooked aspects of loans between family members or friends. Both borrower and lender have responsibilities, though most of them fall on the person lending the money.
The first thing the IRS wants is clear proof that this is a loan and not a gift. That means charging and collecting interest under the IRS rules for applicable federal rate. The minimum rate in 2021 was 0.25% for loans of less than three years 0.58 % for loans of three-to-nine years 1.15% for loans more than nine years.
If the parties involved are not paying and collecting at least that much in interest, the IRS could deem the money a gift and apply gift taxes, depending on the amount.
The next step is to draw up legal documents for the loan. If the loan is for a home, that includes a deed of trust and recording the loan with the county.
What Kinds Of Loans Have Imputed Interest
The rules for below-market loans apply to several kinds of loans:
- Gift loansloans between friends and family members other than spouses
- Compensation-related loansloans from an employer to an employee or independent contractor
- Loans from a corporation to one or more of its shareholders
- Any loan made specifically to reduce someone’s tax responsibility
- Certain loans made to continuing care facilities under a contract
How To Borrow From Friends Or Family
The main advantage of receiving a loan from a friend or family member is that your lender is more likely to be flexible about the amount borrowed and payment arrangements. That means you could borrow 100% of the amount you need at a very low-interest rate possibly 0% and get an affordable monthly repayment schedule.
Treat a personal loan issued by a loved one with the same respect and professionalism as you would a loan from a bank. If you plan to borrow money from a bank, credit union or other lending institution, you already know you must be prepared to sign a legal contract outlining your obligations to the lender: On time payments until the loan is paid in full. This contract is called a promissory note.
Should it be any different if you borrow money from friends or family? Not really. Even though they may have known you for years or even a lifetime, they still need assurance that youll pay them back as promised. The fact you know them really well doesnt remove any of the obligations and responsibilities associated with taking on a loan.
It is a wise move to draw up and sign a loan contract regardless of your relationship with the lender. This protects both parties in case of a disagreement. A loan agreement between two individuals is more simplistic but very similar to a standard bank promissory note.
Basic terms for a loan agreement with family or friends should include:
- The amount borrowed
- Repayment terms
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Alternatives To Family Loans
When weighing the pros and cons of a family loan, also consider alternative options that may provide more cash and less risk to family relationships.
Personal loans: You can borrow a personal loan from a bank, credit union or online lender. You get a chunk of cash and repay it in monthly installments over a period of two to seven years. Personal loans can be used for nearly any purpose, including consolidating debt or home improvements.
Personal loan rates range from 6% to 36%, with the lowest rates reserved for borrowers with good to excellent credit . Some lenders, like online lenders and credit unions, offer loans to borrowers with low credit scores. Bad-credit loans can have rates at the high end of a lender’s APR range, but they’re much more affordable than payday and other no-credit-check loans.
Types Of Loans That Can Be Subject To Restructuring By The Irs
- Gift Loan any below-market-rate loan in which the forgone interest is in the nature of a gift
- Demand Loan any loan that is payable in full at any time on the demand of the lender. This also includes any loan with an indefinite maturity.
- Term Loan any loan that is payable on a specific date
The IRS may treat the loan as a gift, despite the fact that a note was given at the time of transfer, if the IRS deems the transfer is not genuine and was not made in good faith.
Example: A $100,000 note between a father and son, which the father does not expect to ever be repaid. Even if the note is properly documented, the IRS will deem the transfer a gift. A gift tax return must be filed, and tax will be calculated if it exceeds the $15,000 per recipient gift tax exemption .
If the lifetime exemption amount has not been fully utilized, then no money actually has to be paid to the government, as it will merely reduce the free amount available for future gifts and for transfers to beneficiaries at death.
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How Much Money Can You Lend A Family Member
There’s no legal limit on how much you can lend to family as long as you have a written agreement and charge the minimum interest rate. If you attempt to cancel the debt or forgive any of the interest, though, the IRS may consider it a gift, which would apply toward your gift tax exclusion limit for the year.
Should I Lend Money To A Family Member Its A Much
In fact, the best place to get a loan may be from your family. Loans from family members can be a great deal, particularly for the borrower but you may have heard the common warning: Never lend money to a family member.
These loans have potential for both financial and personal downsides, as well as possible tax consequences. Here are a few things to know before making a family loan.
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Consider A Business Loan
Entrepreneurs can consider a variety of loan options when starting a business. Some popular funding choices for small-business owners include business credit cards, microloans backed by the Small Business Administration, an SBA-guaranteed loan from a bank or community development organization, or a traditional business loan from a bank or peer-to-peer lender.
When Should I Consider A Family Loan
Loans between family members can be risky. Before changing hands, consider introducing these conditions.
- Loan terms: The borrower and the lender should ideally agree on a repayment plan and an interest rate before making a loan. The terms of the loan must be included in a signed contract.
- Legal remedies: If the borrower does not respect the credit, the lender must decide whether to sue a family member or absorb the financial loss. If you cannot lose money, it may not make sense to borrow it.
- Limits of Use: For example, cash advances from unsecured loans, including family loans, are sometimes not considered to be valuable sources of mortgage financing.
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Irs Tax Rules For Imputed Interest
Lend someone money at zero interest, and you don’t make any profit from the deal. Therefore, you might assume that the loan doesn’t have any tax implications for you. In many cases, though, you’d be wrong. The tax code expects you to charge a certain amount of interest for a loanand even if you don’t, you can be taxed as if you did. The IRS refers to this as “imputed interest.”
Other Family Loans That Are Safe From Tax Consequences
You dont have to worry about family loans being subject to gift tax rules if:
- You lend a child $10,000 or less, and the child does not use the money for investments, such as stocks or bonds.
- You lend a child $100,000 or less, and the childs net investment income is not more than $1,000 for the year.
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How Do I Report A Family Loan To The Irs
The IRS requires that a loan between family members be executed with a formal, written agreement detailing payback terms and a minimum interest rate. You then just need to report any interest you receive as taxable income each year. The borrower may be able to deduct interest from their taxes, depending on the purpose of the loan.
Prevent Irs Loan Restructuring And An Unexpected Tax Bill
The IRS will deem any forgone interest on an interest-free loan between family members as a gift for federal tax purposes, regardless of how the loans are structured or documented. Interest will be imputed if it is interest-free or at a rate below the AFR. The interest forgone, which is the difference between the actual interest charged and the federal AFR rate, is deemed to have been transferred from the lender to the borrower as a gift subject to gift taxes, and then the borrower to the lender as interest income, which must then be recognized on the lenders individual and state tax returns.
The second exception is if the aggregate outstanding amount of gift loans between individuals does not exceed $100,000, the imputed interest amount for income tax purposes is limited to the borrowers net investment income for the year. However, there is a de minimis rule: if the borrower had less than $1,000 of net investment income for the year, the investment income for this exception is deemed to be zero.
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Tax Ramifications Of Gifting And Loaning Money To Family Members
Its natural for families to help each other out, sharing their good fortune with those they love. So, what if a child or grandchild wants to purchase a home or car and needs some help? Should you gift them the money, or is a loan the better option? There may be business, personal or financial reasons to choose either of these methods. However, below we look at the question from a tax perspective, exploring these two common ways to financially lend a hand to members of your own family.
Is Adequate Interest Being Charged
If an intra-family transfer is a loan, the next question to consider is, Are you charging adequate interest? A loan is considered below market if you charge less than a minimum interest rate, which is determined by the applicable federal rate . The federal government periodically sets the AFR, and the rate varies depending on the type and term of the loan.
For example, the minimum rate for a demand loan is the short-term AFR, compounded semi-annually. So, the minimum rate varies during the life of the loan. The easiest way to ensure you charge enough interest for a demand loan is to use a variable rate thats tied to the AFR. For a loan with a set term, use the AFR thats in effect on the loan date.
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Tips For Legitimizing A Family Loan For Tax Purposes
Although a handshake between family members is a loan agreement, the IRS assumes that there are cash transfers between family members unless there is no evidence that the creditor expects to respect the terms of repayment.
Follow these steps to make sure the loan is the real deal in the eyes of the law.
Accept a payment plan
Family loan rules can be complicated if the loan agreement does not include repayment terms. A good practice for loans between family members is to establish a repayment schedule. The borrower can make a payment every month or repay the loan in a few years.
The Internal Revenue Service introduced a minimum percentage rate called the applicable federal rate. The minimum interest rate varies depending on whether the loan is short term , medium-term or long term .
In February 2019, the federal annual rate applicable to a short-term loan was 2.57%. A creditor who does not collect at least the applicable federal tax should pay taxes on the unknown interest.
Put it in writing
Although a handshake is technically a loan agreement, writing the payment terms offers something concrete that shows the creditor must meet the debt repayment terms.
Keep your records
The documentation does not stop after the loan is issued. The borrower and the lender must record payments and monitor the balance of the loan. Good record keeping will help reduce taxes and keep family members on the same page.
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High Cost Of Family Loans
Financing isn’t cheap. Just look around the market and see how much you’ll pay your bank or other financial institution in interest and fees. That’s why many people turn to family and friends. These lenders may be less inclined to charge you anything on top of the amount of money they advance you.
In fact, a 2018 survey conducted by Finder revealed that roughly people borrowed as much as $184 billion annually from friends and family. As many as one in three people surveyed borrowed money from someone they knew, with the average loan amounting to about $3,300.
Americans are turning to friends and family for loans rather than the big banks to avoid spiraling into more debt and defaulting on regular payments, explained Steve Trumble, CEO of American Consumer Credit Counseling. Even though consumer and student loan debts have each surpassed the trillion-dollar mark, young Americans are still the most willing to help out friends and relatives in need, which could exacerbate their own debt as well.
The key to lending money to family membersespecially if you expect the money to be repaidis to treat the deal as a business loan and keep all your emotions out of it.
How To Lend Money To Family And Not Regret It
What Happens When You Default
Like any loan contract, youre legally on the hook for the debt. If you fail to abide by the terms of the agreement, your lender in this case, your loved one can take legal action against you. With the contract as proof, the lending party can sue in small claims court, get a judgment and then pursue collection activities on the loan such as wage garnishment or property liens just like other creditors.
If you cannot negotiate more reasonable loan terms privately, a lawyer might be able to either negotiate on your behalf to include part of the balance due in a debt settlement agreement or add it to a debt consolidation loan. It is important to take action before a judgment is entered in small claims court because the lending party can often pursue your personal assets, bank accounts and wages.
Loan Agreements With Family And Friends
There is a right way to execute a loan agreement with family or friends that protects both sides from harm.
Money is a funny thing when it passes between family and friends, especially if you are the one borrowing from or lending to a member of your family or a close friend.
The Federal Reserve Survey of Consumer Finances says loans from family and friends amount to $89 billion each year in the United States. A company called Finder did some math after a 2018 survey and said the number was more like $184 billion. Either way, theres a lot of cash flowing between family and friends.
The most popular reasons for asking family members or friends for a loan are to start a business or purchase a home. A national survey by Fundable said that 38% of startup businesses relied on money from family or friends. The National Association of Realtor said that 52% of first-time home buyers used money from family, mostly parents, or friends to buy a house.
Another good reason for seeking a loan from loved ones is when a family member becomes unexpectedly unemployed or is hit with a sudden illness. Other popular reasons include buying a car, a computer or other technical equipment or something more personal like an engagement ring or to pay for a family vacation.