A low or interest free family loan is one of the best strategies to defend against the many proposed increases in income and inheritance taxes and to take advantage of today’s low interest rates.
The family loan lowers income and property taxes in line with current legislation, but also has flexibility so it can be adapted to many likely changes in the tax code. A family loan provides more than tax benefits. He provides immediate assistance to children or grandchildren instead of keeping them waiting to inherit.
The Federal Reserve’s zero-interest 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 this minimum interest rate is very low today because it is based on the yield on US Treasury debt.
Loans between family members occur frequently, but many people do not realize that there are specific provisions of the tax code that apply to them. There are also well-established strategies for increasing family wealth after taxes through loans.
If there is no interest rate charged on a loan between family members or a rate lower than the minimum rate set by the IRS, the tax code imposes an interest rate equal to the minimum rate of the IRS.
The lender must report interest income at the minimum interest rate set by the IRS, although no funds are received. The borrower may be able to deduct the same amount as the mortgage interest or business interest if the requirements are met.
In addition, when a loan is made to family members, it is assumed that the lender will give the borrower the imputed interest. In most cases, the annual gift tax exemption is more than enough to keep the gift free of tax consequences. In 2021, an individual can make gifts of up to $ 15,000 per person with no gift tax implications in accordance with the annual gift tax exemption. A married couple can jointly donate up to $ 30,000.
To avoid accruing interest, you must enter into a written loan agreement specifying the loan amount, interest rate and repayment terms. Simple loan agreement forms can be found on the Internet.
The interest rate must not be lower than the minimum interest rate set by the IRS for the month the agreement is signed. You can find the monthly minimum rate by searching the Internet for “applicable federal rate” for the month the loan agreement was entered into. The rate depends on whether the loan is short-term, medium-term or long-term, and whether the interest is monthly, quarterly, semi-annually or annually. If the loan amounts to a significant amount, it is recommended that you consult with a tax accountant or real estate planner to ensure that the correct interest rate is being charged.
There are two important exceptions to the rules for imputation of interest.
A loan of $ 10,000 or less is tax deductible. Make a relatively small loan and the IRS won’t bother with it.
The second exception applies to loans of $ 100,000 or less. Imputed income rules apply, but the lender may quote imputed interest at the lower of the applicable federal rate or the borrower’s net investment income for the year. If the borrower does not have a large investment income, this exemption can significantly reduce the amount of imputed income reported.
If the loan agreement provides for regular payments of interest or interest and principal, these payments must be made and documented. The more you make the transaction look like a real loan, the less likely it is that the IRS will try to tax it as something else, like a gift.
A written loan agreement can also prevent any misunderstanding between the borrower and your property or other family members.
Suppose Hi Profits, son of Max and Rosie Profits, wants to buy a house and needs help with a down payment. Max and Rosie lend Hi $ 100,000. They charge 2.15% interest on the loan, which is the applicable federal rate in May 2021 for a long-term loan on which interest is charged semi-annually.
Under the loan agreement, regular interest payments are not required and Hi does not. Max and Rosie will have an imputed income of $ 2,150 per year, which must be included in their gross income. They will also be considered a $ 2,150 per year Hi gift. Until they give Hi other gifts in excess of the annual gift tax exemption ($ 30,000 for joint gifts by a married couple), there will be no gift tax consequences.
He can record the loan as a second property mortgage. This would allow him to deduct the imputed interest from his tax return, although he did not make any cash payments.
Max and Rosie have two loan costs. The first cost is the investment income they could get on $ 100,000.
The other cost is income tax, which they will have to pay on the imputed interest income.
A family loan is now a particularly good strategy.
As has been the case for several years, very low interest rates allow an adult child or grandchild to invest on a loan and earn more than the interest charged on the loan.
One strategy is for the borrower to invest the money for several years, pay the lender the principal and interest, and pocket the excess profit. It is also a way for a lender, who is probably in a higher tax bracket, to lower family income tax by taxing the borrower’s income or profits.
Another strategy is long term. A parent or grandmother or grandfather issues the loan on terms that do not require repayment for many years. After a while, the lender forgives the loan and interest, turning them into a gift.
Some people plan to forgive a debt if they are confident that the borrower will not waste money. Others are planning to include loan forgiveness in their wills and estate plans.
The possibility of forgiveness is especially important now, when the law on inheritance and gift tax may change.
Suppose you are giving money or property to an adult child today. If the lifetime property tax exemption and gift are reduced, or likely to be reduced later this or next year, making your property tax deductible, it is a simple step to sign a loan forgiving document to match the gift with today’s high exempt amount, and not a new, lower tax exemption.
A real estate loan with a low tax base can also be a good strategy. One current proposal is to prevent heirs from increasing the tax base of the inherited property to its current fair market value, known as raising the tax base. Instead, the property was to be subject to capital gains tax on any gains that occurred during the tenure of the deceased owner.
Suppose you are giving a stocked adult child a present that is much appreciated as long as you have it. If the escalating basis is canceled, you can forgive the loan and turn the loan into a stock gift for the child.
This has at least two benefits. One of the benefits is that a child can be taxed lower on capital gains than you or your property, which reduces the tax burden compared to owning stock on his estate.
Another advantage is that the child can sell the stock whenever he or she wishes. It can be sold in stages over the years or when it lowers taxes. If you continue to own shares, taxes will be paid shortly after your death.
You do not need to forgive the loan unless the tax laws change or the changes affect you. The borrower can repay the loan by returning the money or property to you.
If you intend to forgive an outstanding family loan at the time of your death, be sure to include this in your will. It is standard practice to include in the will or annex details of the loan and that they are forgiven in the event of the death of the lender. If the creditor wants all family members to be treated equally, the will must also state that the amount inherited by the debtor is reduced by the amount of the forgiven loan.
Family loans are widely used and there are reasons why they should be used more widely today. Make sure you take additional steps to avoid IRS issues and maximize your family’s after-tax wealth.