Obtaining financing can sometimes be difficult. If your child or another relative is having a hard time getting a loan from a commercial lender, you may be willing to help out by lending the money yourself.
Have a Written Agreement
Start by putting the loan agreement in writing. This may seem like an unnecessary formality, but without a written loan document, the IRS could argue that the transaction was a gift instead of a loan, potentially creating gift tax issues. Having written documentation is also important in case the borrower fails to repay all or part of the loan.
Charge Adequate Interest
The second step is setting an interest rate. While there’s no rule against interest-free loans or loans that have below-market interest rates, in a family context they can lead to tax complications. If you don’t charge sufficient interest or no interest at all, the difference between the amount of interest you actually receive (if any) and the amount you should have received — referred to as “imputed” interest — is taxable to you, as if you received it. In addition it becomes a gift to the borrower, as if you transferred it back, thus possibly generating gift tax reporting.
You can avoid the below-market loan issues and the imputed interest rules by charging interest at the appropriate “applicable federal rate” (AFR). The IRS publishes AFRs monthly for loans of different maturities. These rates have been relatively low recently, reflecting the current market interest rate environment. For example, this month, July 2019, the annual AFR (using a monthly compounding assumption) is:
- 2.11% for a short-term loan (three or fewer years)
- 2.06% for a mid-term loan (more than three but no more than nine years)
- 2.47% for a long-term loan (more than nine years)
For a term loan (a loan other than a demand loan discussed below), the rate can remain fixed for the life of the loan. In order to avoid he below-market loan issues, you should charge at least the AFR in effect on the day the loan was made, based on the term of the loan.
For a demand loan (one that gives you the right to demand full repayment at any time or a loan with an indefinite maturity), in order to
avoid imputed interest issues, you have to charge a floating AFR that is at least equal to the short-term AFR in effect for each semi-annual period that the loan is outstanding.
If you want a fixed rate of interest on a demand loan and you don’t want the loan to become a below-market loan, the terms of the loan should provide that the rate at any given time is the higher of the stated fixed rate or the minimum rate required by the regulations.
When you lend your child or a family member no more than $100,000, you won’t have to report any imputed interest if the borrower’s net investment income amounts to $1,000 or less. You can also sidestep imputed interest on small loans of no more than $10,000 (all outstanding principal) provided the borrowed funds aren’t used to buy or carry income-producing assets.
There are a lot more considerations and complexities regarding the below-market loan rules and we are here to help. Give us a call to see how we can help you and your particular situation.