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Rules Regarding No-Interest Family Loans

Written by Nickel - 9 Comments

I’ve written in the past about using gift funds from a family member to aid in the purchase a home, including how to write a mortgage gift letter. But what if you’re interested in using a no-interest loan from a family member, as opposed to a gift?

Well, assuming that you’ll be using these funds in conjunction with a standard mortgage, it’s always possible that you could ease the underwriting process by using a gift letter to satisfy the mortgage lender, even though the transaction is truly a loan (note that I’m not recommending this — just saying that it’s possible). While this might get around some difficulties with regard to underwriting, however, there are still some important IRS rules to deal with when it comes to making (or accepting) a loan of this sort…

In short, the IRS doesn’t want people to use family loans as a tax dodge — consider the case of a wealthy individual who provides their child (who resides in a lower tax bracket) with a no-interest (or even low interest) loan such that they can invest it and pay far less in taxes. While this was once possible, that loophole has now been closed. Indeed, the IRS now assumes that interest is being charged on the loan amount, and they further treat this uncollected interest as a gift. And if the amount of uncollected interest exceeds the Federal gift tax exclusion, the lender may be liable for gift taxes.

As is the case with nearly all IRS regulations, however, there are exceptions. First and foremost, if the amount of the loan is $10,000 or less, the IRS will simply ignore it. And for loans of up to $100,000 the IRS will not get involved as long as the borrower’s investment earnings don’t exceed $1,000 per year.

If your loan doesn’t fall under one of these exemptions, then it’s subject to the IRS’s imputed-interest rules (this is sometimes also referred to as ‘phantom’ interest). What this means is that the IRS will do you the favor of calculating the interest dues based on IRS-set rates (the ‘applicable federal rate’ or AFR), and will then tax the lender for the foregone interest. Another wrinkle (and this one actually works in your favor) is that the taxable interest cannot exceed the borrower’s investment earnings for the year. Note that, even if this is not an interest-free loan, the imputed-tax rules could kick in if the interest rate falls below the AFR — in this case, the imputed interest would be proportional to the difference between the AFR and the actual rate being charged.

As a quick (and very simple) example, assume that Bob borrows from his parents an amount in excess of the $10,000 threshold under which the IRS will ignore the transaction. This is a no-interest loan that is intended to help Bob by a house but, as it turns out, Bob ends up earning $1,700 in interest and dividends from his investments. Now let’s assume that the IRS does the imputed interest calculations and concludes that Bob should have paid $3,300 in interest. In this case, the loan interest is taxable (since Bob’s investments earned more than $1,000), but the taxable amount (for the lender) is just $1,700 instead of $3,300 (i.e., it’s capped at Bob’s investment earnings).

Another thing to watch out for is that, if the loan is used to purchase an income-producing asset, the loan automatically falls under the imputed interest rules.

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[Source: H&R Block]

Published on May 9th, 2006 - 9 Comments
Filed under: Mortgages, Real Estate, Taxes

About the author: Nickel is the founder and editor-in-chief of this site. He's a thirty-something family man who has been writing about personal finance since 2005, and guess what? He's on Twitter!

9 Responses to “Rules Regarding No-Interest Family Loans”

1
mapgirl Says:
May 9th, 2006 at 8:04 am
Actually, the gift amount is now $11K. That’s what my mortgage banker told me two years ago when I got a gift from my folks.
2
nickel Says:
May 9th, 2006 at 8:10 am
You are correct that the gift limit is now $11k. But the cutoff for the IRS ignoring a loan is still $10k. If it goes over $10k, then it is potentially subject to the imputed interest rules.
3
GoldenFortune Says:
October 16th, 2007 at 1:20 pm
what does it mean “And for loans of up to $100,000 the IRS will not get involved as long as the borrowerâ€™s investment earnings donâ€™t exceed $1,000 per year.” as stated in your article. Also, is there a “button” to forward your articles via e-mail to a friend? (Did I miss it?) Thanks!
4
John C. Lynch Says:
September 10th, 2008 at 10:57 am
My daughter just finished graduate school and has borrowed over $125,000 over the past 2 years. She tried to consolidate her loans but was told by several companies that she owed too much money. She has come to me and her mother for help. We have the money to help her but I told her about the $100,000 limitation and I didn’t want to have trouble with the IRS. She was in an intership program last year and didn’t earn much. The school district would not pay her while she was in the program. She had a part time job at a coffeee bar but was injured away from work and could not work. She owns her own condo and has moved a roommate in to help with her expenses. She started back to teaching this September and with her master degree her gross salary will be $60,000 per year. The school distict pays her salary on a 12 month basis. She gets her first pay check at the end of September but we don’t know how much it will be. Can you help me or comment on the situation as I would like to give her the $125,000 but I will need the interest for the money we are lending and losing that intertest on the Money Market certificate that I will taking the money from. I will loan her the money in mid October at the expiration of the Money Market certificate so I will not be penalized for cashing it in. I have come up with an interest rate of .800% per annual. I figured her payment to me based on 119 months wouldbe about $1.084.75/month. Her mother told me last night that is too much that we should keep it under $1,000 or she wouldn’t have any money to live on. Her condo payment will be about $1,200 per month plus condo fees etc all of this would amount to about $!,500.00 per month (including her mortgage payment).
5
Roger Young Says:
January 4th, 2009 at 2:29 pm
I wish to loan my son $50K at 5% simple annual interest toward purchase of a new home with payment due upon sale of previous home and “forgive” the interest payments as a gift under the $11K rule. Is there special contract wording I should follow?
6
Barbara Trelease Says:
March 9th, 2009 at 2:01 pm
My mother will lend me money (>10k, <100k) to pay off my credit card balances, rather than using outside debt consolidation, etc. It is not to purchase a house or invest. What is the required interest rate, to make things less complicated with the IRS? What sort of document is required?
7
Thanh Vu Says:
June 16th, 2009 at 6:52 pm
I will loan my son 205K to buy a house for his primary residence. He is single and is making about 50K a year with around $800 in investment income. He is legally liable for this debt. What interest rate am I allow to charge him and what portion of the interest is taxable to me and tax deductible for him?
8
scott Says:
January 3rd, 2010 at 9:15 pm
what is the definition of “investment earnings”? Is it only referring to the stock, mutual funds? If I have rental income, does it count as investment income?
9
panghalili Says:
July 6th, 2011 at 12:58 pm
Is there a difference if the gift is from a US person in the US to foreign person in a foreign country?

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