While your natural instinct may be to want to help a family member in need of financial assistance by offering an intrafamily loan, it’s important for you to be aware of the potential pitfalls of offering this type of help before you move ahead. If improperly executed, intrafamily loans could mean costly negative tax consequences for you – including unexpected taxable income, gift taxes, or both. Here are some savvy tips to consider before you open your checkbook.
Create a paper trail.
In general, to avoid undesirable tax consequences, it’s imperative that you be able to demonstrate that the loan was bona fide. You can easily accomplish this by 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 the time when payments were made.
By documenting the loan and payments received, in writing, you’re sure to make your intentions clear and help avoid loan-related misunderstandings.
Demonstrate an intention to collect.
Even if you think you may eventually forgive the loan, ensure the family member who’s borrowing makes a few payments, at least. By having some repayment history, you’ll make it more difficult for the IRS to argue that the loan was really an outright gift. However, if there is not a realistic expectation that the potential borrower can repay the loan, it’s safest not to extend the loan in the first place. If you do and the IRS audits you, they’re sure to treat such a loan as a gift that carries with it tax consequences.
Charge interest if the loan exceeds $10,000.
If you lend more than $10,000 to a relative, you should charge the Applicable Federal Interest Rate (AFR), at a minimum. In any case, 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. This will increase your chances of having to use some of your lifetime estate and gift tax exemption.
Use the annual gift tax exclusion.
If you want to help your family member, but don’t want to use up any of your lifetime estate and gift tax exemption, you can safely 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 both you and your spouse are making the gift) without paying gift taxes or using any of your lifetime exemption. Just know that you’ll still have interest income in the year of forgiveness.
Forgive or file suit.
If an intrafamily loan that you intended to collect on is in default, don’t let it sit too long. To prove this was a legitimate loan that went bad, you’ll need to take appropriate legal steps toward collection. If you know you’ll never collect and can’t bring yourself to file suit, begin forgiving the loan using the annual gift tax exclusion, if possible.