4 Tax implications Of Loan To Family Members

When we talk about loans, the first thing that comes to mind is a bank loan to buy a car or a mortgage. However, that’s not the only option for getting money for your needs.

The most economical way to borrow is from your relatives or close friends. It can be the first thought that pops into your head when looking at unsatisfactory paystubs.

A family loan has its advantages such as much lower interest rates because your friends or relatives save you from predatory high-interest loans.

You would also get no unnecessary formalities, such as applying for a loan or waiting for approval.

Read on to know some tax implications of loans to family members.

1. IRS Requirement

Family loans must continually be formalized with a simple contract that both parties sign. It is an IRS requirement.

For example, loans over $10,000 are subject to IRS tax rules. How you set and describe the loan can create tax consequences for the lender, the borrower, or both at once. In addition, there are potential tax liabilities that vary depending on the size of the loan.

In other words, if you lend your loved one more than $10,000 and you didn’t charge or receive a penny of interest income on the family loan, the IRS requires you to pay income tax.

This is the income tax on the earned interest income the IRS believes you should have received, based on the AFR at the time you made the loan.

Suppose the family loan is explicitly used to buy or refinance a home. In that case, the borrower and lender should consider the benefits of securing the loan with an adequately recorded mortgage, deed of trust, or deed of lien.

In the absence of an agreement, the IRS may treat the transaction as a gift rather than a loan, and it may be subject to gift tax rules. 

2. Gift Tax

By 2022, the annual gift tax exemption increased to $16,000 per giver and receiver. In 2021, that limit was $15,000.

Using this tax exemption, a giver can present someone else, such as a relative, real friend, or stranger, assets up to the limit each year without paying federal gift tax. 

If someone exceeds this amount, other rules apply. The receiver is responsible for paying the gift tax. Under special arrangements, the giver may agree to pay the tax instead. 

The prevalent rule is that any gift is taxable. However, there are numerous exceptions to this rule. As a general rule, the following gifts are not taxable.

  • Gifts that do not exceed the annual calendar year exception.
  • Education or medical expenses you pay for someone.
  • Gifts to a spouse.
  • Gifts to a political organization.

The gift tax rate is 18%-40%, with the maximum rate set for gifts over one million dollars.

3. Credit

There is a family credit for those who don’t want to make an outright gift. It can encourage financial discipline in the form of regular payments.

The IRS requires that any loan inside the family be made with a signed written contract, a fixed repayment plan, and a minimum interest rate.

Each month the IRS publishes an index of interest rates called applicable federal rates.

You must use Applicable federal rates under the Internal Revenue Code, including calculating assigned interest on below-market loans between family members.

There are three levels of AFR depending on the duration of the family loan:

  • Short-term rates for loans with a maturity of up to three years.
  • Medium-term rates for loans with three to nine years maturities.
  • Long-term rates for loans with more than nine years of maturity.

Suppose the lender chooses not to charge the family member an interest rate equal to or greater than the applicable, Applicable federal rate when the family loan is made.

In that case, the IRS can impute interest by taxing the lender on the discrepancy between the AFR and the interest rate charged by the lender.

In most cases, by ensuring a family loan with an adequately recorded mortgage deed of trust or security deed, the borrower will have the legal right to deduct the interest paid on the loan from the taxes at the end of the year.

Both parties should secure the loan by a registered mortgage, deed of trust, or security agreement and adequately record with the appropriate governmental authority to carry out the deduction legally.

Consideration should also be given to the issue of delinquency. When a family member cannot repay a loan, the lender rarely reports it to the credit bureau, let alone a collection agency.

However, if the lender wants to deduct the impaired loan on their taxes, the IRS requires evidence of an attempt to collect the unsettled funds. 

4. Forgiveness equals gift

Family loans, including interest or credit in whole or in part, can be forgiven. When a debt is forgiven, it does not signify that the borrower must treat it as repayment of debt income.

A forgiven loan will not be considered as such if the borrower is insolvent or the lender forgives or cancels the loan. Instead, it would be viewed as a gift from the lender.

On the other hand, forgiving or cancelling family debt does not mean that the lender must recognize unpaid interest. 

We strongly stimulate all families to discuss their financial strategies and potential estate planning and tax issues with their trusted attorney, financial advisor, or tax advisor.

However, we hope that instead of borrowing money, you will do your best to make sure that the amounts in your paystubs fully cover all of your needs.

Conclusion

A family loan contract can even be concluded orally through a handshake, which we do not recommend to you but there are disadvantages as well.

Borrowing money is always a risk of destroying a trusting relationship within a family or ending a friendship.

After all, if the amounts in your relatives’ paystubs also begin to reduce, the requests to repay the loan will be very uncomfortable.

The information on such a loan does not affect your credit rating because the credit bureaus do not record it. Such loans have tax consequences for both parties.

Hence, it is vital to consider the disadvantages of family loans and the potential embarrassment or family drama if something goes wrong.

Before joining into a loan contract with a family member, discuss your concerns with them. 

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Post Author: Abimbola Joseph

Abimbola Joseph is a creative content developer who derives pleasure in encouraging individuals to be the best they can be in all relevant facets of life. She believes that we all have a better version of ourselves which can be leveraged to impact others and make the world a better place. Connect with me on Instagram @abimbolajoe.

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