Lending money to a relative? Avoid a tax trap

Suppose a relative wants to borrow money for a business venture or to buy a home. It’s true that family loans can raise problems. But if you’re going to do it, take the tax law into account. Otherwise, you could have an unexpected problem on your hands.

Here’s what to watch out for

It all has to do with “imputed interest” rules that may apply if you don’t charge the going rate of interest on the loan. Essentially, the IRS treats the loan as if interest were required, even if you’re not charging any interest, or you’re imposing an unusually low rate. Thus, the interest is “imputed” to you — the lender — based on IRS figures.

In other words, the IRS treats it like you’ve received taxable interest from the relative, even though you may not be getting a penny. Thus, you could be facing a tax bill that you probably weren’t counting on.

Fortunately, the tax law provides two exceptions to these “imputed interest” rules:

  • If you lend your relative less than $10,000, you have no tax worries, unless the money is used to purchase income-producing property. You can charge no interest (or an extremely low interest rate) without any tax repercussions.
  • If the money is a gift, you also don’t have to deal with interest. You and your spouse can each give up to $14,000 ($15,000 in 2018) to an individual each year.

There are additional complexities for some family loans, but those are the main tax rules to address. If possible, stay below the thresholds for either of the two exceptions. Alternatively, charge an interest rate and use a formal loan document resembling one found at a bank. Your professional advisors can help you with the details.

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