January 11, 2010

Loans in the Family

By Cesar Estrada, Senior Manager, Tax & Business

Related Service Tax & Business

Loans in the Family Tax & Business

Lending money to a family member may result in significant tax consequences if you charge less than the market rate of interest, or if you charge no interest at all. This is because the amount of the foregone interest (the interest you should have charged less the interest you actually charged, if any) is considered a gift to the borrower.

In the worst situations, the tax law can transform a low- or no-interest family loan into the following possible events:

  • The lender is treated as having charged the full market interest rate.
  • The lender is considered to have made a gift to the borrower equal to the foregone interest.
  • The borrower is treated as having paid the lender the full market interest rate.

Consequently, you, as the lender, might actually be required to pay income tax on phantom interest income and you also might be treated as having made a gift equal to the foregone interest.

Even so, there are benefits to below-market loans to family members. For example, if your annual gifts to the family member (including the foregone interest) do not exceed $13,000 in 2009 ($26,000 for 2009 if your spouse joins in the gift), there are no gift tax consequences. In fact, you can generally avoid these tax problems if the principal balance of all of your loans (below-market rate or not) to the family member do not exceed $13,000.

Favorable rules also apply to below-market interest family loans that do not exceed $100,000, as long as tax avoidance is not one of the principal purposes of making the loan. The amount of phantom interest income you are considered to have earned on the loan cannot exceed the familymember borrower’s net investment income. And, if his or her net investment income does not exceed $1,000, you are not taxed on any phantom income at all. Keep in mind, however, even though you avoid being taxed on phantom income, you are still treated as having made a gift of the foregone interest subject to annual gift tax exclusions as noted above.

Given the historically low applicable federal interest rates currently in effect, loans between family members often make sense without causing major tax complications. To structure such loans in the manner most favorable to your particular situation, it is best to seek the advice of a tax professional.