The low- or no-interest family loan is one of the best strategies to hedge against the numerous proposed increases in income and estate taxes and to take advantage of today’s low interest rates.
A family loan reduces income and estate taxes under the current law but also has flexibility so it can be adapted to many likely changes in the tax code. A family loan made provides more than tax benefits. It provides immediate help to children or grandchildren instead of requiring them to wait to inherit.
The Federal Reserve’s zero interest rate policy is another reason family loans are a good strategy today. The IRS requires many loans between family members to charge at least a minimum interest rate to avoid negative tax consequences, and that minimum interest rate today is very low because it is based on the yields on U.S. Treasury debt.
Loans between family members occur frequently, yet many people don’t realize that there are specific tax code provisions addressing them. There also are established strategies to maximize the family’s after-tax wealth by using the loans.
When no interest rate or a rate below the IRS-determined minimum rate is charged on a loan between family members, the tax code imputes an interest rate equal to the IRS minimum.
The lender must report interest income at the IRS-determined minimum interest rate, though no cash is received. The borrower might be able to deduct the same amount as mortgage interest or business interest if the qualifications are met.
In addition, when the loan is among family members the lender is assumed to make a gift of the imputed interest to the borrower. In most cases, the annual gift tax exclusion is more than sufficient to prevent the gift from having any tax consequences. In 2021, a person can make gifts up to $15,000 per person with no gift tax consequences under the annual gift tax exclusion. A married couple can give up to $30,000 jointly.
To avoid the imputed interest, there should be a written loan agreement stating the amount of the loan, the interest rate, and the repayment terms. Simple loan agreement forms can be found on the Internet.
The interest rate should be at least the minimum interest rate set by the IRS for the month the agreement was signed. You can find the minimum rate for the month by searching the Internet for “applicable federal rate” for the month the loan agreement was made. The rate depends on whether the loan is short-term, mid-term, or long-term and on whether interest compounds monthly, quarterly, semiannually, or annually. When the loan is of a significant amount, it’s a good idea to consult with a tax accountant or estate planner to be sure the correct interest rate is charged.
There are two important exceptions to the imputed interest rules.
A loan of $10,000 or less is exempt. Make a relatively small loan and the IRS won’t bother with it.
The second exception applies to loans of $100,000 or less. The imputed income rules apply, but the lender can report imputed interest at the lower of the applicable federal rate or the borrower’s net investment income for the year. If the borrower doesn’t have much investment income, this exception can significantly reduce the amount of imputed income that’s reported.
If the loan agreement calls for regular payment of interest, or interest and principal, those payments should be made and documented. The more you make the transaction look like a real loan, the less likely it is the IRS will try to tax it as something else, such as a gift.
A written loan agreement also can prevent any misunderstandings between the borrower and your estate or other family members.
Suppose Hi Profits, son of Max and Rosie Profits, wants to purchase a home and needs help with the down payment. Max and Rosie lend $100,000 to Hi. They charge 2.15% interest on the loan, which is the applicable federal rate in May 2021 for a long-term loan on which the interest is compounded semiannually.
Regular interest payments aren’t required under the loan agreement, and Hi doesn’t make any. Max and Rosie will have imputed income of $2,150 each year that must be included in their gross income. In addition, they will be treated as making a gift to Hi of $2,150 each year. As long as they don’t make other gifts to Hi that put them over the annual gift tax exclusion amount ($30,000 on joint gifts by a married couple), there won’t be any gift tax consequences.
Hi can have the loan recorded as a second mortgage against the property. That might enable him to deduct the imputed interest on his income tax return, though he made no cash payments.
Max and Rosie have two costs to the loan. The first cost is the investment income they could have earned on the $100,000.
The other cost is the income taxes they’ll owe on the imputed interest income.
The family loan is a particularly good strategy now.
As has been the case for a few years, very low interest rates make it possible for an adult child or a grandchild to invest the loan proceeds and earn more than the interest charged on the loan.
One strategy is for the borrower to invest the money for a few years, repay the lender the principal and interest, and pocket the excess earnings. This also is a way for the lender, who probably is in a higher tax bracket, to reduce family income taxes by having the income or gains taxed to the borrower.
Another strategy is longer-term. A parent or grandparent makes a loan with terms that don’t require any payments for years. After a period of time, the lender forgives the loan and interest, converting it into a gift.
Some people plan to forgive the debt once they’re confident the borrower won’t waste the money. Others plan to include forgiveness of the loans in their wills and estate plans.
The forgiveness option is especially important now that the estate and gift tax law might change.
Suppose you make a gift of money or property to an adult child today. If the lifetime estate and gift tax exemption is reduced or likely to be reduced later this year or next year, making your estate taxable, it is an easy step to sign a document forgiving the loan so the gift qualifies under today’s high exempt amount instead of the new, lower exempt amount.
A loan of property with a low tax basis also might be a good strategy. One current proposal is to eliminate the ability for heirs to increase the tax basis of inherited property to its current fair market value, known as the step-up in basis. Instead, the estate would owe capital gains taxes on the appreciation that occurred during the deceased owner’s holding period.
Suppose you make a gift to an adult child of stock that’s appreciated a lot while you’ve owned it. If the step-up in basis is eliminated, you can forgive the loan and convert the loan into a gift of the stock to the child.
That establishes at least two benefits. One benefit is the child might be in a lower capital gains tax bracket than you or your estate, reducing the tax burden compared to holding the stock in your estate.
Another benefit is the child can sell the stock when he or she chooses. It can be sold in stages over the years or when it would minimize taxes. If you continue to own the stock, the taxes would be due shortly after you pass away.
You don’t have to forgive the loan if the tax law doesn’t change or the changes don’t affect you. The borrower can repay the loan by returning the money or property to you.
When your intention is to forgive family loans that are outstanding at your death, be sure to state that in your will. The standard practice is to state in the will or an attachment the details of the loans and that they are forgiven on the lender’s death. When the lender wants all family members to be treated equally, the will also should state that the amount inherited by the debtor is reduced by the amount of the forgiven loan.
Family loans are in wide use, and there are reasons they should be in wider use today. Be sure you take the extra steps needed to avoid problems with the IRS and maximize family after-tax wealth.