If a relative needs financial help, offering an intrafamily loan might seem like the most gracious route to take. But, if not handled properly, such loans can carry substantial negative tax consequences — such as unexpected taxable income, gift tax or both. Here are some things to ponder before lending a helping hand:
1. Everything should be documented. To avoid undesirable tax consequences, one thing you’ll need to do is show that the loan was bona fide. Doing so should include documenting evidence of:
- the amount and terms of the debt,
- interest charged,
- fixed repayment schedules,
- demands for repayment, and
- the borrower’s solvency at the time of the loan and payments made.
Be sure to make your intentions clear. Help avoid loan-related misunderstandings by documenting the loan and all payments received.
2. Plan to collect repayment. Even if you think you may end up forgiving the loan, ensure the borrower makes at least a few payments. By having some repayment history, you’ll make it harder for the IRS to argue that the loan was really an outright gift. Do some soul searching before giving the loan. If the would-be borrower has no realistic chance of repaying a loan, don’t make it. If you’re audited, the IRS is sure to treat such a loan as a gift.
3. Charge interest if the loan exceeds a certain amount. If you lend more than $10,000 to a relative, charge at least the applicable federal interest rate (AFR). The interest on the loan will be taxable income to you. (If no or below-AFR interest is charged, taxable interest is calculated under the complicated below-market-rate loan rules.) However, if no or below-AFR interest is charged, all of the forgone interest over the term of the loan may have to be treated as a gift in the year the loan is made.
4. Know about gift tax exclusion. Let’s look at an example. If you help a relative buy a house but don’t want to use up any of your lifetime estate and gift tax exemption, make the loan, charge interest and then forgive the interest, the principal payments or both each year under the annual gift tax exclusion. For 2016, you can forgive up to $14,000 per borrower ($28,000 if your spouse joins in the gift) without paying gift taxes or using any of your lifetime exemption. But you will still have interest income in the year of forgiveness.
5. Forgive or take action. If an intrafamily loan that you intended to collect is in default, don’t sit by hoping payments will begin to appear. To prove this was a legitimate loan that went south, you’ll need to take legal action to move toward collection. If you know you’ll never collect but don’t want to get lawyers involved, begin forgiving the loan using the annual gift tax exclusion, if possible.
It is always a smart idea to discuss the specifics of an intrafamily loan with a trusted advisor before opening your checkbook. Don’t let your good intentions place you in the path of tax issues. If executed correctly, you can be of help to your loved one while protecting your own interest. As always, give me a call if you have any questions. I am always happy to help.
Brian E. Ravencraft, CPA, CGMA is a Principal with Holbrook & Manter, CPAs. Brian has been with Holbrook & Manter since 1995, primarily focusing on the areas of Tax Consulting and Management Advisory Services within several firm service areas, focusing on agri-business and closely held businesses and their owners. Holbrook & Manter is a professional services firm founded in 1919 and we are unique in that we offer the resources of a large firm without compromising the focused and responsive personal attention that each client deserves. You can reach Brian through www.HolbrookManter.com or at BRavencraft@HolbrookManter.com.