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Setting Up an IRS-Approved Family Loan

Monday, August 6, 2007 - 00:00
Setting Up an
IRS-Approved Family Loan

CHANTILLY, VA — Today's low-interest-rate environment makes it easy to loan money to family members on favorable terms with full Internal Revenue Service (IRS) approval. But it's critical to set the loan up properly to avoid disqualification or other problems. Here's a rundown of what federal law covers, and why it might be a good time to set up loans now.


Proper documentation is important with family loans. If the person never pays you back and you make a good-faith attempt to collect, you'll want to claim a non-business bad debt deduction. These write-offs are treated as short-term capital losses.

If you don't document your loan and you're audited, the IRS may say the family loan was a gift and disallow a bad debt deduction. In addition, there could be problems because you didn't file a gift tax return.

Doing it right
Nothing in the tax law prevents you from making loans to family members — or unrelated people for that matter. However, unless you charge what the IRS considers an "adequate" interest rate, the so-called "below-market loan rules" come into play.

For example, let's say you loan $50,000 interest-free to your daughter so she can buy her first home. Under the below-market loan rules, this can have unexpected income tax consequences for both you and your daughter, as well as gift tax consequences for you. Who needs the hassle?

The alternative is to charge an interest rate equal to the "Applicable Federal Rate" (AFR). As long as you do that, the IRS is satisfied, and you don't have to worry about any tricky tax rules biting you.

As the lender, you simply report as taxable income the interest you receive. On the other side of the deal, the borrower may be able to deduct the interest expense on his or her personal return, depending on how the loan proceeds are used.

Applicable Federal Rate Made Easy

For instance, the annual applicable federal rates (AFRs) for July 2007:

* 3.66 percent for "short-term" loans of three years or less.

* 3.81 percent for "mid-term" loans of between three to nine years.

* 4.32 percent for "long-term" loans more than nine years.

(Source: IRS)

Interestingly, AFR interest rates these days are reasonable. AFRs are updated each month in response to ever-changing bond market conditions, so rates may not stay this low for long.

Case in point
In the example above, if you decide to lend $50,000 to your daughter, you could charge the mid-term AFR (only 3.81 percent, as of July 2007) for a 108-month loan (nine years). She can pay that same low rate for the entire loan term with the government's blessing.

Say you want to make it a 15-year loan instead. No problem. Just charge a rate equal to the long-term AFR (only 4.32 percent, as of July 2007). Your daughter can pay that same low rate for the entire 15-year loan term.

Note, however, that these rules apply to "term" loans. When you make a "demand" loan, which can be called in anytime, the AFR isn't fixed in the month you make the deal. Instead, you must charge a floating AFR, based on fluctuating short-term AFRs.

The $10,000 Loophole
Under a favorable tax law loophole, you are completely exempt from the below-market loan rules if the sum total of all loans between you and the borrower adds up to $10,000 or less. This includes all outstanding loans to that person, regardless of whether you charge adequate interest. As a result, interest-free loans of $10,000 or less generally don't cause any tax difficulties for either you or the borrower.

So if you believe rates are headed higher in the future, it's best to set up a term loan (one with a specific repayment date or specific installment repayment dates). That locks in today's low AFR for the entire duration of the loan, just like doing so with a personal mortgage.

With this plan, everybody should be happy. You'll be charging an interest rate the IRS considers adequate. The borrower can be pleased knowing he or she is paying a low rate. And you're glad to give a family member or friend some financial assistance without creating any tax complications.

(Sources: Automotive Parts Rebuilders Association, IRS)

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