CASWELL BELL & HILLISON LLP
FRESNO, CALIFORNIA

INTRAFAMILY LOANS SUBJECT TO TAX LAWS

For parents with the financial means to do so, there may be a natural impulse to help a child get started in his or her adult life by making a loan to the child, on terms that are favorable to the child.  But, if the terms are too favorable to the child, the loan could cause undesirable tax consequences.

So-called “gift loans” are subject to imputed interest under the Internal Revenue Code.  To the extent that the interest due on the loan is less than the interest calculated with the AFR, that amount will be “imputed” income to the parent, even though it was not in fact collected by the parent. 

This means that, if the interest rate charged by the parent is too low (or is zero), the parent will be required to report income in an amount equal to the difference between the actual interest rate paid by the child and the AFR.

Interest Rate Linked to the AFR
For a loan from a parent to a child, the IRS measures the interest rate on the loan against a benchmark interest rate, the “applicable federal rate” (AFR), which it adjusts each month.  The AFR is the federal short-term rate, compounded semiannually, for the period for which the loan is outstanding.

As of July 2008, the AFR is 4.2%.  See this link for the AFR table:

The accumulated interest is computed differently for demand loans and term loans.  For demand loans, the foregone interest is the excess of the amount of interest payable during the calendar year, if interest had accrued at the applicable federal rate.  For term loans, the foregone interest is the excess of the amount loaned over the present value of all payments.  The present value is computed as of the day the loan is made, using the AFR in effect on the day the loan is made, compounded semiannually.

The IRS will also treat the same amount as a gift to the child, requiring the filing of a gift tax return.  The better choice may be to go forward with the loan, but with the child repaying the loan with enough interest to avoid the tax bite.  Think of this approach as generosity tempered with practicality and as a borrowing position for the child that is closer to the “real world” marketplace.

Exceptions
There are two important exceptions to this rule.  First, if the principal amount of the loan to a relative does not exceed $10,000, and the loan is not used for an income-producing investment, the IRS will not impute any interest. 

Second, loans of up to $100,000 do not lead to imputed interest if the borrower’s net investment income in a given year does not exceed $1,000.

To avoid the income tax or gift tax ramifications for all kinds of intrafamily loans, the simplest approach is to use an interest rate that is at least as high as the AFR.  Also, although it may seem unduly formal among relatives, it is advisable to set forth the terms of the loan in a written agreement, signed by all parties.  Not only does this protect against faulty memories, but it decreases the odds that the IRS will consider the entire transaction to be a gift rather than a loan.

© Caswell Bell & Hillison LLP          Attorneys and Lawyers, Fresno, California