Last week a client asked me this question. He wanted to help his daughter and her husband buy their first home by giving them a low-interest loan. He had heard there were some important things to keep in mind about how to do this but didn’t know what they were.
In fact recently a number of people have asked me about this. Loan interest rates are still low right now but it’s also more difficult to obtain a mortgage. So if you have an adult child who wants to buy a home or start a business, it’s a great time to help out.
Today’s low interest-rate environment makes it easy to lend money to family members on very favorable terms with full IRS approval. You can give your child a good deal and probably still earn more interest than you would with a certificate of deposit — a win-win situation. But here’s what you need to know about the tax rules for loans to relatives.
First, if you don’t charge what the IRS considers an “adequate” interest rate, you may end up paying income taxes on the interest you should have received. The IRS has special rules for below-market loan rules come into play. They are complicated, and they are not taxpayer-friendly.
For instance, say you want to loan $100,000 interest-free to your daughter so she can buy her first home. Under the below-market loan rules, you would be forced to calculate and pay income taxes on imaginary interest income that you “should” have collected but did not. Your tax bill goes up accordingly, and that part is not imaginary.
The IRS publishes a schedule every month that taxpayers can use to look up the IRS minimum adequate interest rate. If you use that rate for your loan, then all you have to do is report as taxable income the interest you actually receive.
Fortunately, you don’t have to charge much interest to satisfy the IRS. The AFRs for term loans made in April of 2011 are as follows:
- 0.55% for short-term loans of up to 3 years.
- 2.46% for mid-term loans of more than 3 years but not more than 9 years.
- 4.17% for long-term loans of over 9 years.
These are annual rates that assume monthly compounding of interest. Each month, the government’s AFRs are updated to reflect current bond market conditions. So rates will probably not stay this low for too much longer. Until they start going up, however, the time is ripe for parents to make low-interest home loans to their kids.
Example: Say you decide to lend $100,000 to your daughter in April so she can buy her first home. For a nine-year loan, you could charge an interest rate equal to the April mid-term AFR of only 2.46%. That’s a sweet deal for her (and a generous move by you). Your daughter can pay that same low rate for the entire nine-year loan term with full IRS blessings. Say you are willing to make a 15-year or 20-year or even a 30-year loan. No problem. Just charge 4.17% interest, which is the AFR for long-term loans made in April. Your daughter can pay that same low rate for the entire loan term, and the IRS will have no problems with the deal.
On her Form 1040, your daughter can claim itemized home mortgage interest deductions for the interest paid to you. However, deductions are only allowed if you take the legal step of having the loan secured by your daughter’s home.
Important Point: The same considerations would apply to a loan from a grandparent to a grandchild or from any family member to any other family member.
Make a Term Loan (Not a Demand Loan)
In contrast to a term loan, a demand loan has no specific repayment date or schedule. You as the lender can demand full repayment at any time. The problem with a demand loan is that you must charge a floating AFR to avoid falling victim to the below-market loan rules. If interest rates move up (as they probably will), you will have to charge higher rates.
On the other hand, when you make a term loan (one with a specific balloon repayment date or specific installment repayment dates), you are allowed to use the same fixed AFR for the entire loan term. With current AFRs being so low, I think a demand loan is clearly the way to go — assuming you are OK with charging a fixed low rate.
For Small Loans, You Can Usually Charge Zero Interest with IRS Approval
Under a favorable exception, you are exempt from the bothersome below-market loan rules if the sum total of all loans between you and the borrower in question add up to $10,000 or less. You must count all outstanding loans from you to that person, whether you charge interest or not. Thanks to this taxpayer-friendly rule, you can probably loan up to $10,000 to your child and charge 0% interest – if that’s what you want to do.
Read more here: How to Lend Money to an Adult Child – SmartMoney.com