Richard Gilmartin, CPA
60 E 42nd Street, New York, NY 10165
Family Loans -- Tax Considerations
Obtaining financing to start or expand small businesses and buy homes can sometimes be difficult. If your child or grandchild 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. In that situation, you'd want to be able to show you're entitled to write off the unpaid amount as a nonbusiness bad debt.
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, 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). 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, in January 2021, the annual AFR (using a monthly compounding assumption) was:
- 0.14% for a short-term loan (three or fewer years)
- 0.52% for a mid-term loan (more than three but no more than nine years)
- 1.35% for a long-term loan (more than nine years)
These are the minimum rates for intra-family loans initiated in January 2021. For a term loan, the rate can remain fixed for the life of the loan. For a demand loan (one that gives you the right to demand full repayment at any time), you have to charge a floating AFR to avoid imputed interest issues.
When you lend your child or grandchild 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.