Tax Ramifications of Loaning Money to Family Members– March 21, 2017 by Nicki Rococi

It’s a common practice for family members to loan money to one another, for anything from purchasing a home or car, to making loans between related trusts or to an estate. For the person making the loan, it can be an easy way to earn additional interest income or, in the case of loans between trusts, to freeze growth and transfer appreciation. For the person receiving the loan, he can bypass closing costs and expenses associated with a bank loan, or, if he has poor credit, can help him obtain what he wants without being turned down by financial institutions. Regardless of which side you are on, the flow of money must be monitored carefully. If making a loan within the family is not handled properly, the IRS could consider the transaction a gift versus a loan — which could lead to very different tax consequences. 

Structure is Key

Intra-family loans must be made and carried out in good faith. They should include a signed written agreement with the interest rate being charged and a fixed schedule for repayment. The borrower should be solvent and there should be an intent to make sure the debt will be repaid by the borrower.
 
While families may be inclined not to charge an interest rate, establishing a rate is actually very important in the eyes of the IRS. Before 1984 it was easy for taxpayers to make interest-free loans, as the IRS did not mandate interest to be charged or that interest-free loans would be considered income and/or taxable gift transfers. However, the U.S. Supreme Court held in Dickman v. Commissioner that “the lender’s right to receive interest is a ‘valuable property right,’ and that the transfer of such a right through an interest-free loan is a taxable gift.” This case led to comprehensive below-market loan reform and the enactment of IRC Code Section 7872. Section 7872 goes beyond the gift tax area the Dickman case addressed and governs below-market loans under various circumstances, including loans between family members. Section 7872 does not govern loans where the interest rate is sufficient — meaning at a rate no lower than the applicable federal rate (AFR).
 
Specifically, an interest rate of at least the AFR must be used on loans exceeding $10,000 to an individual. The AFR is published monthly on the IRS website, but since the AFR is constantly changing, use caution when attempting to refinance loans when the AFR goes down. Refinancing a family loan too many times could raise the question of whether or not the loan is a bona fide debt. A good practice when refinancing a loan is to pay down some principal or otherwise provide the lender some consideration in return for the lender agreeing to refinance at the lower interest rate. 

Forgiveness Can Be a Gift

Intra-family loans, including the interest or the loan in full or in part, can be forgiven. When a loan is forgiven, it does not mean that the borrower must consider it as discharge of indebtedness income. The forgiven loan will not be considered as such if the borrower is insolvent or the lender forgives or cancels the loan. Instead, it will be considered a gift from the lender. IRS Code Section 102 excludes gifts from the definition of gross income. On the other side, the forgiveness or cancellation of an intra-family debt does not mean that the lender must recognize the unpaid interest. Be careful not to forgive accrued interest each year, or the IRS will look at the original loan as a gift versus a bona fide loan. 
 
Loaning money to family members can be very nice way to “pay it forward.” Just make sure you are paying, and receiving, the funds in compliance with IRS guidelines to help ensure the effort is well worth it for all involved. 
 
Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts and circumstances.