CARL WATTS & ASSOCIATES

November 5, 2012

www.carlwatts.com
office@carlwatts.com
Washington DC
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Loans to Family & Friends
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The actual repayment of the loan can be setup in several ways. You can set installment payments in equal amounts over the life of the loan with each payment going towards both the interest and principal of the loan.

You can set a lump sum payment structure allowing the borrower to pay off the entire loan at a specified future date.

A third way to structure repayments is by setting up a balloon payment. This type of repayment structure schedules smaller recurring payments with a large lump sum at a future date.

Once you have a basic loan contract, the following step is to declare the interest income on your Form 1040 Schedule B and you’re all set.

There are some other advantages to having a basic loan contract.

  • If the borrower dies, or if the loan cannot be collected, the lender my want to write the loan amount off on their taxes as a bad loan deduction, which can reduce the total taxes paid.

  • If a parent lending money to a child dies, the documentation can explain whether the child must pay the loan back to the estate, or whether the loan is to be forgiven.

As mentioned above, the first exception is known as the $10,000 exception. The rules for below-market loans do not apply to loans of $10,000 or less, and to loans for which the proceeds are not directly used to buy income-producing assets (such as stocks or bonds).

The second exception is more complicated and it’s known as the $100,000 exception. This exception states that the loan must be for $100,000 or less, and the borrower's net investment income (loosely defined as interest, dividends, and short-term capital gains, less any investment expense) cannot exceed $1,000. If the borrower's net investment income exceeds $1,000, the lender will be required to report interest income in an amount equal to the net investment income of the borrower.


As for the borrower, rules are also complicated. How the money is used will determine if the interest paid is deductible or not. For example:

  • If the loan goes toward paying personal debts and obligations, the interest paid on the loan will be nothing more than non-deductible personal interest;

  • If the money is used for business purposes, the interest paid will likely be a business expense, deductible on the appropriate business schedule;

  • If the proceeds were used to purchase investments, then the interest would likely be considered investment interest, subject to the investment interest rules;

  • If the loan is used to purchase or refinance a primary or second residence, the interest might be considered deductible home mortgage interest (assuming that the property is secured by the note in the form of a mortgage or trust deed).

So, the interest rules can get quite complex for both parties. You should make sure you know how the rules will work for (or against) you, and, as usual, help from a professional is always the best option.

We have no intention whatsoever to offer advise on whether you should lend money to family members and friends or not; the purposeof this newsletter is to inform you on potential tax implications such loans may have on your tax return and finances.

First of all, if you want to help out a family member or a friend without considering it a loan and expecting any interest, you should take into consideration the annual gift exclusion, which for 2013 is of $14,000, up from $13,000 for 2012.

If you’re considering loaning money to anybody, you should know about the IRS imputed interest rules.

IRS imputed interest is interest that the IRS creates on a loan, and taxes the lender on, even if the lender is not actually collecting interest.

The rules were created to prevent wealthy people from avoiding taxes by loaning money to their children in lower tax brackets, then letting the children invest the money so that the investment income would be taxed at the lower rate. The money stays in the family, but instead of being taxed at the wealthy parent's tax rate, the money is taxed at the much lower child's tax rate.

If the loan is less than $10,000, the IRS will simply ignore it. If it is less than the annual gift exclusion, the IRS will consider it a gift.

A higher amount will trigger the imputed interest rules and the IRS will "impute" interest on the loan and impose an income tax on the imputed interest, so you end up paying taxes on the imaginary, or "imputed," interest even though you are not actually collecting any interest.

In order to avoid this, you need to charge the minimum interest rate on all loans, including loans made to family members. The IRS establishes the minimum interest rates, which vary depending on the size and the term of the loan.

The transaction needs to be structured as a loan. You have to set terms, such as loan amount, loan period, payment period, interest rate, and collateral. As long as you have a basic contract with all those details written, agreed upon, and signed, then the money will be considered a loan and not a gift.

The applicable federal rate (AFR) you must have depends on how long the loan is for:

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Short term (less than three years);
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Mid-term (three to nine years);
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Long term (more than nine years).

The AFR is published each month and you can see an index of those rates at the IRS website index of Applicable Federal Rates rulings.

The Internal Revenue Service will consider any departure from market rates to be a gift, and if the amount is higher than the annual exclusion gift, it will be taxed accordingly.

A clear record of payments made and a signed promissory note can help a lender prove that the transaction was a legitimate loan and not a monetary gift.