Inter-family loans can come with IRS strings
Loaning money to family members is a common and often informal affair: parents front a mortgage down payment for an adult child, for example, with an expectation that it’s repaid over time (or not). Aside from the emotional risks of loaning money to a family member who may or may not be expected to repay the debt, the Internal Revenue Service could be a vested third party whose involvement could complicate the transaction.
Ultimately, the IRS wants taxpayers to charge reasonable interest rates on inter-family loans. To find a “reasonable” rate, the IRS calculates minimum applicable federal rates (AFR) for loans covering different time periods. If you charge family members or heirs less than this rate, the difference would be counted as a gift to the borrower (loans of less than $10,000 that are not used to purchase income-producing property are excluded). Alternatively, you could calculate implied interest payments and then offset that amount with your $15,000 annual gift exemption to the borrower. When interest is waived completely, the IRS considers the amount of interest the borrower would have paid as a taxable gift.
Whether your inter-family loan is extended with or without interest, it’s always a good idea to document the terms and stated interest rate in case the IRS ever decides to audit the loan. If you’re considering making an inter-family loan and want to ensure compliance with IRS rules, please contact a Cranbrook Wealth investment professional.