If you've ever considered giving a personal loan to a family member, it's important to understand the potential tax implications. The IRS says that tax issues involve imputed income, the gift tax, or bad debts. That means issues can arise when you first lend money, when you are repaid the loan, or if you are not repaid the loan. What does this mean?
Family loan tax implications
- Imputed income. This is revenue that is presumed to be earned but is neither recognized nor received by the assumed recipient. The IRS may impute interest on a loan at the “applicable federal rate” (AFR) when a lower rate (or no interest) is charged. The agency then assesses tax on the excess of the imputed interest over the amount required by the terms of the loan.
- Gift tax. If or when the IRS imputes phantom interest, it also creates phantom taxable gifts. The imputed interest is treated as though the borrower actually paid it to the lender, as a result, the lender returned it to the borrower as a gift. Since the lender “constructively received” the additional interest, he or she owes income tax on it. Since the lender then presumably gave the interest back to the borrower, he or she also owes gift tax on it, unless an exclusion or credit applies.
- Bad debt deduction. Typically, a loan made for a business purpose that goes bad is deductible, either against ordinary income as a short-term capital loss. Although, when the party that defaulted is related, the IRS may demand clear and convincing evidence that the original loan was not actually a gift. Once a loan is re-characterized as a gift, no bad debt deduction will be allowed if the loan isn’t repaid, and the lender also may owe gift tax on the principal unless an exclusion or credit applies.
Unless a loan directly relates to the purchase or carrying income-producing assets, it is not necessary to charge interest nor will interest be charged on a family loan of $10,000 or less. Without a written document imposing interest at the applicable federal rate or higher, the loan will likely be considered a gift and will not be deductible if it is not repaid.
However, if the stated interest rate is below the applicable federal rate, interest will be imputed on a family loan over $10,000. Although, unless the principle exceeds $100,000, imputed interest will be limited to the borrower’s annual net investment income, and not interest will be charged if that income is $1,000 or less.
Unintended tax consequences can result when you give a family member a loan. It’s important that you always have a written agreement on family loans to document the transaction for the IRS. At Summit CPA we are here to assist you with all of your tax and financial needs. Contact our office at (260) 497-9761 to schedule an appointment to find out how we can make your life easier.