Lending money to family members probably dates back to the invention of money. Tax problems can arise when you first lend money, as you’re being repaid, or if you’re not repaid. The issues usually involve imputed income, gift tax, or bad debts.
- Imputed Income – Imputed income is revenue presumed earned but neither recognized nor received by the alleged recipient. The IRS may impute interest on a loan at the “applicable federal rate” when a lower rate or no interest rate is charged. The agency then assesses tax on the excess of the imputed interest over the amount required by the terms of the loan. Interest need not be charged and will now be imputed on a family loan of $10,000 or less unless the loan is directly related to purchasing or carrying income producing assets.
- Gift Tax – When the IRS imputes phantom taxable gifts. The imputed interest is treated as though the borrower actually paid it to the lender, whereupon the lender returned it to the borrower as a gift. Since the lender “constructively received” the additional interest, he or she owes the income tax on it. Since the lender then presumably gave the interest back to the borrower, he or she also owes gift tax on it, unless an exclusion or credit applies.
- Bad Debt Deduction – Normally, a loan that goes bad is deductible, either against ordinary income (if made for a business purpose) or as a short term capital loss. However, when the defaulting party is related, the IRS may demand clear and convincing evidence that the original loan was not actually a gift. Once a loan is re-characterized as a gift, no bad debt deduction will be allowed if the loan isn’t repaid and the lender may also owe gift tax on the principal unless an exclusion or credit applies.
Obviously, lending to relatives can create unintended tax consequences. You should always have a written loan agreement on family loans to document the transaction for the IRS. You should also always talk to your accountant before making a loan. An accountant can help structure the terms to ensure your helpful act is gratifying and tax-smart for the entire family.