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. Notwithstanding the virtues of such generosity, the cold reality is that, if the terms are too favorable to the child, the loan could end up with some undesirable tax consequences.
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.
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 sets each month. Currently, that rate is about 5%. 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. The IRS will also treat the same amount as a gift to the child, requiring the filing of a gift tax return. (There would be no gift tax due, however, unless the parent had used up the $1 million lifetime gift tax exclusion.) From the standpoint of the child’s taxes, he or she may be able to deduct the amount of the imputed interest on a loan secured by a residence.
There are two important exceptions to this scenario. If the 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. In addition, 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.