Lending to Family Members and Potential Tax Consequences
"Families are the compass that guides us. They are the inspiration to reach great heights, and our comfort when we occasionally falter." - Brad Henry
Individuals who are strapped for cash and in a pinch often look to family members for help, and rightfully so -- your immediate family has been with you since day one, and to ask a friend (even a really good one) for money can be uncomfortable with too much that can go wrong.
But you should know a few tax ramifications before cutting a check to those closest to you.
Family Is Informal
Often, transactions between family members are informal and not properly documented (the agreements don't have an interest rate or require regular payments). Parents or grandparents who offer a loan often won't hold the recipient to a payment schedule (depending on the severity of one's financial troubles).
However, according to tax rules, sharing within the family presents a conundrum. Any family loan payment without an interest rate is charged as income to the parent from the child. Therefore, the interest is accumulated through that "income," and parents or grandparents are responsible for reporting interest income on their taxes.
It's important to note that in 2024, parents or grandparents can classify the loan as a "gift" up to $18,000, and a married couple can give a total of $36,000.
A Formal Agreement
Please consider a formal, written agreement when sharing money between family members to avoid tax complications.
In short, the document should include an agreed-upon (IRS-approved) interest rate depending on the length of the loan—monthly, quarterly, etc.
The borrower should make these payments on a regular basis. If he or she does not, then the IRS could question if the loan was really a loan in the first place, and might count the amount as a gift in sum.
Two important rules on imputed interest:
- A loan less than $10,000 is tax-exempt -- the IRS will not fret over that small amount.
- However, loans over $10,000 are a little different. Parents or grandparents that offer such a larger loan have the ability to report imputed interest at a lower federal rate.
A Real Life (fictional) Example
Take (fictional) Billy and his (fictional) parents: Scott and Karen. (This is not real-life tax advice…this is entertainment)
Billy wants to buy a home (seller financing), and Scott and Karen would like to help him with the down payment. They loan Billy $100,000 and charge 11.49% APR interest—an average interest rate for an unsecured loan (and acceptable to the IRS).
An option for Billy is to count the loan as a second mortgage on his home. That way, he could potentially deduct imputed interest on his tax return. Scott and Karen's loan to Billy is a nice gesture, but it hurts them financially in the long run. They could have received investment income on the loan paid to Billy, and now it will be reflected in their income taxes through imputed interest.
OH NO …Life Happened
Billy was injured in a serious accident that created a disability for a couple of years, preventing him from being able to work. His parents wanted to help stave off the financial ramifications of this and told him not to worry about the payments on the second mortgage. Imputed Interest rears its ugly head!!
This could have turned into a tax issue for Scott and Karen. They were stepping outside of normal lending procedures and “set aside” the loan. Instead, their wise tax advisor had them document the gift of the loan forgiveness, preventing a possible “imputed interest “ tax issue.
However, the real problem for this family of three, and your family should a similar situation arise, is when things are not formally documented and agreed upon. A quick internet search will provide a loan agreement form.
The key is over-communication and filing away the information correctly. Nothing in life is guaranteed, and if you write down important information within the context of a family loan, you might prevent problems for others.
Helping family is a good thing. But even though I'm biased, ensuring your taxes are squared away is nearly as good.
BE THE ROAR not the echo®
Warmly, Janet
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