Know the rules associated with making loans to family members

This article was featured in the Personal Finance section of the El Nuevo Herald on Sunday, January 31, 2016. The link to the published article can be found at the bottom of this post.

We all want to help our family in times of need, especially our children, but we also want them to have a sense of financial responsibility so we avoid making outright gifts.  Instead we make loans, but few people understand the rules related to family loans.

The IRS will take the position that “loans” to our family are gifts unless the loan is a “bona fide” loan.  How do we prove a loan is a bona fide loan?  These are some of the facts & circumstances the IRS will look at:

  1. There is a real prospect for repayment.  For example, a loan to a child who is working and will have the ability to pay interest and repay the loan at some point, this is reasonable.  If, however, the loan is to a child who isn’t working and cannot keep a job, it is very unlikely they will be able to pay interest or repay the loan.
  2. You charge interest annually using a rate of at least the amount published by the IRS.  The IRS publishes monthly rates called the AFR.  The rate required will depend on the term of the loan.
  3. The loan is documented with a signed promissory note containing the terms of the loan.

Showing annual payments of at least the interest due and principal repayments will further substantiate the fact that there was intent to establish a real loan and not a way to avoid having to file a gift tax return.

As an example, let’s assume your son wants to buy his first home and you want to help.  You make a loan to him of $100,000 this month, January 2016.  Your son agrees to repay the loan principal within 10 years including interest annually.  If you look up the rates applicable for a 10-year loan, you will need to charge him interest of at least 2.65% annually.  (Much lower than the rate he would be able to get with a local bank).

Based on this fact pattern, you should draft a document detailing the terms of the loan and each year your son should pay you $2,650 of interest.  This income will be “interest income” to you reportable on your income tax return.  As far as your son being able to deduct the interest, it will only qualify as “mortgage interest” if the loan is secured by the home, which can be done, but it will require an extra step with an attorney.

If on the other hand, you decide to ignore all the rules on family loans, the IRS can treat the entire “loan” as a gift to your son, which will require the filing of a gift tax return and will reduce the amount you are allowed to give away during your life or at death ($5,450,000).

Alternatively, if you don’t charge him any interest, the amount that you are required to charge him (in our example $2,650) would still be treated as income to you and also a gift to your son.  This may be okay unless you have also made other cash gifts, which would cause the total annual gift to exceed $14,000, the maximum you can give to any person without filing a gift tax return.

There are certain exceptions to the loan rules – for loans that don’t exceed $10,000 and $100,000.  If the total of all loans with your child is $10,000 or less, you can ignore all the loan rules.  For loans of $100,000 or less, it will depend on how much “investment income” your child earns each year.  It is wise to discuss these rules with your financial advisor.

Link to the article in El Nuevo Herald:

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