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On Friday, I talked about using your 401(k) to pay off your mortgage. Then, over the weekend, a reader wrote in to ask about a different scenario – a family member lending you the money to pay off your mortgage. Robert asked:
The short answer is that personal loans are not themselves typically taxable — assuming that it’s truly a loan, and will be paid back. However, if there is no (or not enough) interest being charged, the IRS can figure what the interest on the loan should have been and treat it as though the borrower had incurred.
These calculations are based on the “Applicable Federal Rate” for a short, medium, or long-term loan. The AFR changes monthly. You can see the most recent values at IRS.gov – click here. You can learn more about “Below Market Loans” by reading IRS Publication 550.
Since the lender is required to report the interest as taxable income, this could create some tax issues. In most cases, however, this isn’t a big deal, as the unpaid interest can be treated as a tax-free gift from the lender to the borrower. This works without any complications as long as the total amount of unpaid interest is less than the current year’s gift-tax exclusion, which currently stands at $13k.
Now for some good news… With some exceptions, this rule does apply to loans under $10k. In addition, if the loan is for $100k or less, the interest that must be reported by the lender (or treated as a gift) is limited to the total of the borrower’s net investment income for the year. And if the borrower’s net investment income is $1k or less, the amount is treated as zero.
But what if you the lender ends up forgiving the loan and you never repay all or a portion of it? In that case, the amount forgiven will be treated as a gift, and will be subject to the annual and/or lifetime gift tax exclusions. If the lender is in no danger of exceeding their lifetime limit, the forgiveness can be done all at once.
If, on the other hand, the lender wants to preserve their lifetime exclusion, then they can forgive the principal (and ongoing interest) in chunks of up to $13k/year (per recipient) until the entire amount has been forgiven.
As always, I highly recommend that anyone facing complex tax situations like this seek out professional advice. It’s not terribly expensive to buy an hour or two of a tax pro’s time, and you could save yourself a significant chunk of money, not to mention a bunch of headaches.
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