Tip of the Month for August 2004

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TIP - Loans To Family Members - Avoiding Pitfalls
It is very likely -if it hasn’t happened already- that someone in your family will need a helping hand. Maybe it is a child who is buying a first home, a grandkid that needs help with education expenses, or a brother who has lost his job. If you are in a position to help out and decide to do so, be aware that the IRS has some rules on gifts and interest income that you need to understand. And be advised that the IRS, anxious to drum up more revenue, is being especially vigilant regarding gift taxes and interest income.

Here’s a checklist to help you avoid penalties:
  1. Document the loan. Record that the money is actually a loan and include information on payment terms and collateral for the loan (if applicable). Also make a note in the paperwork that the borrower was solvent when you made the loan. This helps prove that you expected repayment and that the money was not intended as a gift. Documentation will help you to avoid gift taxes on money that wasn’t intended as a gift - taxes that cut into your gift tax exemption.<.li>
  2. If the loan is for a family member who is a buying a house, take the necessary legal steps to secure the note with the residence. You will need a lawyer to do this. If you neglect this, the borrower will not be able to deduct the interest he/she pays on the home mortgage. Bypassing this might cost you and the borrower dearly. If you failed to secure the loan and were audited later, you would be in trouble with Uncle Sam, and, the borrower might face criminal charges for falsifying a mortgage application.

  3. Set an interest rate. If you don’t, the IRS just might set one for you - commonly known as imputed interest - and tax you on it (regardless of whether you actually received any interest or not. If you don’t charge interest, the IRS considers the money a gift and you are back in the pitfalls outlined in point # 1.

  4. Avoid complications and limit individual loans (with or without interest) to $10,000. Imputed interest and the related income tax and gift tax complications outlined above, can be avoided (in most cases), if the loans you make to an individual do not total more than $10,000. This loan limit will not interfere with the $11,000 annual tax-exempt gift limit.

  5. If your generosity extends beyond $10,000, you may wish to explore the "$100,000 rule" with assistance from your tax professional. This rule, which applies if the borrower’s net investment income is no more than $1,000 for the year, may allow the imputed interest rate on the loan to be set at zero. As lender, you must obtain an annual statement disclosing the borrower’s net investment income. There are various tax considerations and qualifying criteria to evaluate. A tax professional can help you determine how this would effect your tax position.
Bottom Line: Do your homework, get professional advice from your tax consultant, and don’t let the impulse to be generous blind you to potentially costly tax pitfalls.


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