Obtaining financing to start or expand small businesses and buy homes can sometimes be difficult. Your family member might have a hard time getting a loan from a commercial lender. You may want to help out with a family loan.
Have a Written Agreement
Start by putting the family 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. This can create potential 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 For a Family Loan
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, 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.
You can avoid the imputed interest rules by charging interest at the appropriate “applicable federal rate” (AFR) for the loan term that applies to you. Short-term AFR applies to three or fewer years loan terms, mid-term AFR applies to loan terms of more than three years, but no more than nine years and long-term AFR applies to loans of over nine years. The IRS publishes AFRs monthly for loans of different maturities. These rates have been relatively low recently, reflecting the current market interest rate environment. To see the IRS AFRs, click here.
For a term loan, the rate can remain fixed for the life of the loan. A demand loan has different requirements. A demand loan is one that gives you the right to demand full repayment at any time. For such a loan, you have to charge a floating AFR to avoid imputed interest issues.
Exceptions
When you lend a family member no more than $100,000, the amount that can be added to your taxable interest income under the below-market interest rate rules generally can’t exceed the borrower’s net investment income. Even better, 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.
You can find out more information about the treatment of loans with below-market interest rates here.
If you need help with your small business, give us a call.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice.