Certified Public Accountants

7 Tax Tips for Intrafamily Loans

If you have healthy finances and your family members don't, making intrafamily loans might seem like a good idea. But intrafamily loans can carry substantial negative tax consequences - such as unexpected taxable income or gift tax or both.

Intrafamily loans made at below-market interest rates can raise the reddest of flags. If you make a sizable loan, you may have to report taxable interest income even if you didn't charge any. And if you report taxable interest income, the borrower may not be able to deduct the hypothetical interest expense.

Ill-planned intrafamily loans can also trigger the gift tax. In addition to the loans themselves, foregone interest and forgiveness of bad debts can create gift tax, because the IRS may consider these items as income to the recipient.

Here are seven tips for avoiding tax traps on intrafamily loans.

Tax Tip 1: Leave a Paper Trail

When lending money to family or friends, leave a solid paper trail. An informal intrafamily loan may have unpleasant consequences if the lender dies. For example, Monty lent his son $75,000 but died before Michael made any payments. Because Monty failed to document the loan, it wasn't deducted from Michael's share of the estate. Other family members - who knew about the loan - were upset that the loan was forgiven because Monty didn't keep any loan records. To make your intentions clear - and avoid loan-related misunderstandings - document the loan and payments received.

Of course, other important advantages flow from good loan documentation. If you should later need to write off an intrafamily loan as a bad debt, you'll need to show that the loan was bona fide. To decide whether a debt is bona fide, courts consider:

• Written evidence of the debt,
• Interest charged,
• Fixed repayment schedules,
• Collateral,
• Demands for repayment,
• The borrower's intent to repay and solvency at the time of the loan, and
• Payments made.

Tax Tip 2: Use the Annual Gift Tax Exclusion

Say you want to help your daughter buy a house, but you don't want to use any of your lifetime estate and gift tax exemption. Make the loan and then forgive the interest, the payments - or both - each year under the annual gift tax exclusion. You can forgive up to $10,000 a year ($20,000 if your spouse joins in the gift) without paying gift tax or using your lifetime exemption. But you'll still have interest income in the year of forgiveness.

Tax Tip 3: Show That You Intended To Collect the Loan

Even if you plan to use the gift tax exclusion to forgive the interest and/or payments each year, have the borrower make some payments. By showing at least some repayment history, you'll make it harder for the IRS to argue that the loan was really an outright gift. And if a would-be borrower has no realistic chance of repaying a loan - don't make it up. If you're audited, the IRS likely will treat such a loan as a gift especially if you never intended for the borrower to repay the loan.

Tax Tip 4: Forgive or File Suit

If the borrower defaults on an intrafamily loan that you intended to collect, don't let it sit too long. If you want to prove this was a legitimate loan that soured, you'll need to take appropriate legal steps toward collection. But if you know you'll never collect and can't bring yourself to file suit, you can try forgiving the loan over time using the $10,000 annual gift tax exclusion.

Tax Tip 5: Charge Interest If the Loan Exceeds $10,000

If you lend more than $10,000 to a friend or relative, charge at least the applicable federal interest rate - currently just under 6% on long-term loans. Otherwise, the IRS will treat foregone interest as income to you and as a gift to the borrower, under complicated rules that require the imputing of interest on below-market-rate loans.

Tax Tip 6: Watch Out For Loan Guarantees

If you think you might avoid all these rules by simply guaranteeing rather than making a loan - beware. The IRS views loan guarantees as transfers of economic value. In other words, the IRS may consider it a gift subject to gift tax - which it determines case by case.

Tax Tip 7: Check the Rules

The best loan structure and lending strategy depends on your situation's specifics and loan. For example, you may escape imputing interest income on loans to individuals less than $100,000 if the borrower has no net investment income.

If you're considering lending money at below-market rates or guaranteeing a loan, give us a call. We can help you evaluate the income and gift tax consequences - for both you and the borrower.