Intra-family loans and IRS interest rate rules
Dear Jonathan: If I loan my son $80,000 to pay off his mortgage, would either of us have an issue with the IRS? My son would repay the loan at a set amount each month. I would prefer not to charge an interest fee. Thank you for any advice you can supply.
Jonathan Says: Believe it or not, your question, which is very straightforward, has a rather complicated answer, but I will try to keep it simple. There is no problem with you loaning money to your son so he can pay off his mortgage, but to avoid running afoul of the IRS, you should:
1. Have your son sign a promissory note.
2. Include an interest rate in the note. You want to do both of those things because the IRS does not like intra-family loans and as a general rule presumes that intra-family loans are really gifts unless proven otherwise. Further, if you do not include an interest rate with the loan, you may incur what is known as “imputed interest,” which is interest considered by the IRS to have been received, even if no interest was actually paid.
To avoid having interest imputed by the IRS, you should assign an interest rate that is equal to or above the applicable federal rate (“AFR”) which is the minimum interest rate you can charge. The AFR is published every month by the IRS and can be found at the IRS website at http://www.irs.gov. The AFR that will apply to your loan will be dependent upon the type and length of the loan, so you will want to make sure that you apply the correct AFR. If you don’t have access to a computer or are unsure what AFR to apply, I encourage you to contact a tax professional in your area who can advise you as to the appropriate interest rate to charge.
Some other points to consider:
• Even though you would be charging interest on the loan, you can always gift back the amount of the interest payments your son made (or was supposed to make) over the course of the year. So long as the total amount of interest gifted back to him in any one year is not in excess of $14,000, which is the annual gift tax exclusion amount, you will not incur any gift tax consequences.
• You should make sure that the note your son gives you is secured by a mortgage. If it isn’t, your son will be unable to deduct the interest that he pays you.
• If you end up making a below-interest or no-interest loan to your son, there are many gift and income tax considerations that will need to be taken into account. In that event, I recommend that you further consult with a tax professional who can explain to you the various tax rules and consequences.
I hope this helps. Good luck.
Jonathan J. David is a shareholder in the law firm of Foster, Swift, Collins & Smith, P.C., in Grand Rapids, Mich.