When a family member encounters a financial need, another family member may extend a helping hand by making a “family loan”. With family involved, often the loan terms are quite favorable, such as, “pay me back when you are able”, or, “don’t worry about paying any interest”. Though well intended, an improperly structured family loan can result in unintended tax implications.
No tax law precludes making loans to family members. However, unless a family loan charges what the IRS considers to be an adequate rate of interest, the loan is defined as a below-market loan. If a family loan is interest-free, it is considered to be a “gift loan”. Each month, the IRS publishes what it considers to be an “adequate” rate of interest, called “applicable Federal rates”, or “AFRs”. AFRs vary based upon the term of the loan, whereby: (i) a term not over three years is a short-term loan; (ii) a term over three years but not over nine years is a mid-term loan; and (iii) a term over nine years is a long-term loan. The AFRs for September 2022, using annual compounding, are, 3.05% (short-term), 2.93% (mid-term), and 3.14% (long-term).
If a family loan is interest-free or below-market, the IRS subjects that loan to “imputed interest” rules. In applying the imputed interest rules, the IRS first treats the foregone interest (the excess of interest applying the AFR over the actual interest charged under the loan) as a gift by the lender to the borrower, and then as payment of the “gifted interest” by the borrower to the lender, which must be reported by the lender as income. Application of the imputed interest rules to family loans could therefore result in both gift tax and income tax implications to the lender. The lender may be required to report the deemed gift of the imputed interest on a gift tax return, and must report the deemed receipt of the imputed interest as income on his or her income tax return, even though no actual interest payments are ever received. If a family loan does not impose a defined repayment term, it is considered a demand loan, which means any imputed interest is imposed using the short-term AFRs, compounded semiannually, reported for each separate month the debt is outstanding, or an IRS reported blended rate, as applicable.
Making a loan to a family member should not involve just writing a check. To avoid potential tax implications under the imputed interest rules, the IRS requires a loan between family members to be made pursuant to a signed written agreement, provide for a fixed repayment schedule, and charge a minimum rate of interest as determined by the AFR. Failure to do so risks the IRS restructuring the loan and imputing interest.
Though some limited exceptions apply, if uncertain whether an intended family loan passes the imputed interest test, it is always best to consult with an attorney or other tax advisor before making a family loan. If charging a family member interest, even at the relatively low current AFRs, is not the desired way of providing financial assistance to the family member, it might make better sense to gift the money to the family member. Under current gift tax laws, gifts of $16,000.00 or less to any one individual are not subject to gift tax and are not required to be reported on a gift tax return. Any gift tax imposed on a gift in excess of $16,000.00 may be offset by the corresponding credit associated with the current $12.06 million gift tax basic exclusion amount each of us currently have (though this exclusion amount is slated to decrease to around $6 million commencing in 2026).
The potential tax implications from an improperly structured family loan are very real. If you have questions concerning structuring intrafamily loans or gift transactions, at Bob Bible Law, we have the knowledge and over 35 years of experience to help you navigate these and related transactions.