We frequently run into situations where someone wants to loan money to a family member (or has already done it). Often, the idea of charging interest is distasteful to them. This is—after all—family. It probably will not surprise you to find out that the IRS has ideas about this, and that they are happy to use those ideas to impose complications on your life.
The Theory: As a very general matter, the IRS imposes tax on income, gain-in-value, and certain transfers of wealth. The ability to use someone else’s money has value. Generally, when we use someone else’s money (to buy a car, for example), we pay them for the use of the money (in the form of interest and other fees). We are paying for value (the use of the money that allows us to have the car now rather than later). If there is no charge for the use of the money, we are getting the same value, but at no cost. The IRS says that looks like income. (There is actually some history here that is really interesting to those of us who are full-fledged members of the Geekdom, but we will save that…)
Now, if you go to the appliance store, and they give you 2 years same-as-cash (i.e., 0% interest) on your new dishwasher that you can control from the moon with your phone, the IRS doesn’t tax that. That is a ‘third-party’ or ‘arms-length’ transaction. The store is not doing it to be nice, they are not really ‘giving’ you anything in the true sense of the idea. It is just part of “the deal”, and they are getting paid—it is just somewhere else in the transaction.
But when the loan is to an “insider” (a family member, business partner, etc.) the IRS sees it differently. They say this may not be ‘part of a bigger transaction’, and so it may be taxable as income. And if you do not charge interest, the IRS may impute interest. (They love to impute things.) This means you may have to follow complicated rules (called ‘below-market interest rules’) to compute imaginary interest on the loan, after which you get to pay real tax on the imaginary interest. As a bonus, the IRS might decide that the imaginary interest is a gift, which can present further complications.
There are numerous exceptions to the below market rules for loans under $100,000.00. Maybe we will cover those someday. But this post is about the get-out-of-jail for free card.
And here it is: Document the loan and charge interest. As an aside, you should document the loan anyway. People’s memory grows foggy with time, and you or your family member may get sick, die, or whatever. Avoid future fights between yourselves and potentially other family members and much bad will — write down what you are doing.
As to the interest: It is not enough just to charge some interest. The IRS publishes an interest rate (actually a series of rates based on the length of the loan and how the interest compounds) called the Applicable Federal Rate (AFR). They are below market and based on the bond market. You can find them published monthly on the IRS website. If you charge at least this rate on a term loan you avoid all of the problems. (A ‘term’ loan has a specific repayment schedule or a specific due date; as opposed to a ‘demand’ loan that is due on demand rather than having a specific due date).
As of the day I am writing this, the current AFRs for term loans are as follows (based on loans made this month that charge interest based on annual compounding):
0.64% for “short-term” loans of up to three years.
1.41% for “mid-term” loans over three years but not over nine years.
2.24% for “long-term” loans over nine years.
For a term loan, the minimum interest rate can in effect on the date of the loan can apply to the entire term of the loan. But be careful: for a demand loan (one where you can demand payment at any time) the rate must ‘float’. For each month a balance remains outstanding, the rate must be at least equal to the AFR for that month. This means you must keep up with it, but it also means that the rate could go up, maybe a lot—it is certainly not likely to go down much.
Now—you must include the interest income on your tax return (no surprise). Your family member cannot deduct the interest unless it would be otherwise deductible (mortgage or certain business loans).
Finally, again, please put the loan in writing to make sure the IRS (and the borrower) will respect the deal as a loan rather than a gift. Also because things happen—it could really help to have the intentions recorded in writing and not dependent of recollection and/or the impressions of people that weren’t a part of the original conversation (like siblings). You should also require at least some payment once per year, even if only the accumulated interest. This will keep the statute of limitations from tolling on the note, which could trigger gift issues again.
Follow these simple precautions, and you can give your family-member borrower some great loan terms, avoid family fights in the future, and keep your friends at the IRS off your back.