A Family Loan May Be More Taxing Than You Know


We all know it; people lend money to family members every day.  It’s a good idea, however, to be aware of tax law to avoid getting into more than you bargained for.

In the case that you decide to lend a family member money, should you charge that person interest, you must pay income tax on that interest.  So, for example, if you loan your daughter $100,000 at 5%, that $5,000 in interest is an amount that must be included on your income tax accounting.

If you lend money, whether or not you would chose to do so, the IRS expects that you should charge interest, just like a bank would. You may think otherwise about doing so, but Uncle Sam is quite firm on the matter, declaring an applicable rate known as the “Applicable Federal Rate” (or “AFR.”)  AFR rates vary according to the time the loan was created and the duration of the loan, so it’s prudent to speak with your accountant or do your own research to know what the AFR is for your own unique case.  Even if you charge less than the government-mandated AFR, or if you choose not to charge interest at all, you’re still bound by the law; as you’ll be doing what the government considers a “gift loan” and legal rules apply to that as well.

Before you get too concerned, first know that loans of less than $10,000 are disregarded.  Should you make a loan between $10,000 and $100,000, and choose to charge interest less than the AFR, the difference is considered a gift for which you may have to pay a gift tax.  If the loan is greater than $100,000, not only is the forgone interest considered a gift, but the IRS pretends that the forgone interest was paid to you as interest and you would have to pay income tax on it.  Even though you may not wish to charge your loved ones interest, should you fail to do so, you might be in for an unpleasant surprise come April 15th!

Should you still choose to lend money, know that there are several viable solutions available to you.  One of them is setting up an Irrevocable Trust for your daughter’s benefit. The Trust could be set up so that transactions between you and your Trust are not considered for income tax purposes.  So, if you lent the Trust $100,000, as previously mentioned, the IRS would ignore the forgone interest for income tax purposes.  The forgone interest is still considered a gift. But, the Trust can be designed so that the “gift” to the Trust (of the forgone interest) will be considered a gift to your daughter.  Since you can give $13,000 each year to anyone gift tax-free, this imaginary gift of the interest amount would be ignored by the good ol’ tax man.

Interested?  Ask a qualified estate planning attorney to ensure your loans are structured to avoid unnecessary income taxation.  We at Loquvam Law can provide everything you need.  Call us today to schedule your free consultation.