Making Loans to Your Kids

Making Loans to Your Kids

Albert Ellentuck, Esq., CPA
King & Nordlinger, LLP
any parents want to help their children buy a house, start a business
or meet some other need for cash. Sometimes a loan is more practical
than an outright gift.

Today's low-interest-rate environment makes intrafamily loans
attractive, not only to borrowers but to parents who can make
below-market loans to kids at a time when the alternative is a meager
return from a certificate of deposit (CD). However, care should be
taken to avoid tax traps.

WHEN LOANS EQUAL GIFTS

If you make a formal loan to a child and collect a market rate of
interest, you probably won't incur tax problems.

Trap: Many parents make interest-free or low-interest loans to their
children. Such loans may have gift and income tax consequences.

Under the Tax Code, foregone interest must be "imputed" (implied) on
loans between family members at the applicable federal rate (AFR).

Example: In April 2005, Joe Brown loaned $200,000 to his daughter Ann,
payable in nine years. No interest is being charged.

Loans of three to nine years are considered midterm loans. In April
2005, the AFR used by the IRS for midterm loans was 4.09%.

Result: The imputed interest is $8,180 (4.09% of $200,000) per year.
Each year, Joe must recognize for tax purposes $8,180 worth of interest
income. He also is deemed to have made an $8,180 gift to Ann each year,
on which she pays no interest.

Tax break: Ann may get an $8,180 interest deduction each year.

Example: Ann uses the $200,000 to buy a business (an S corporation with
$200,000 of assets). If she had paid her father interest on the loan
and itemized her deductions, she could have deducted that interest.
Therefore, she can deduct interest that she never actually paid.

What if Ann pays, say, 2% interest on this loan -- $4,000 per year?
This is still 2.09 percentage points below the AFR, so $4,180 worth of
imputed interest would have to be recognized by Joe and, perhaps, could
be deducted by Ann in addition to the $4,000 of interest actually paid.

EXCEPTIONAL TREATMENT

With interest rates currently at modest levels, the tax consequences of
below-market loans aren't as harsh as they would be with higher rates.
Nevertheless, you may benefit by avoiding some of the tax consequences
if you qualify for either of two exceptions...

Exception 1: If the cumulative amount of below-market loans to a given
child doesn't exceed $10,000 at a given time, no interest will be
imputed.

Required: The loan can't be used to buy income-producing investments.

Example: Joe Brown also lends his son Bob $10,000 so Bob can buy a car.
No interest is charged.

Since this loan falls within the $10,000 limit, no interest must be
imputed, so there will be no tax consequences.

Caution: Say Bob uses only $5,000 to buy the car and puts the other
$5,000 into a bond fund. There will be imputed interest on the $5,000
that's invested.


Assuming the AFR is 4.09%, as above, the annual imputed interest would
be $205 (4.09% of $5,000). Joe (the lender) would have to recognize
$205 of taxable income while Bob (the borrower) might have a $205
deduction.

Exception 2: This exception applies to larger loans. If the loans from
one family member to another don't exceed $100,000, there will be no
income tax consequences.

Required: The child's net investment income must be no more than $1,000
each year. Generally, this refers to interest and dividends.

Example: Suppose Joe lends Ann only $100,000 to buy a condo. For the
year, Ann reports $150 in income from interest on a bank account and
mutual fund dividends. She's under the $1,000 allowance, so this loan
has no tax consequences.

But what if Ann's investment income is above the $1,000 limit? Suppose
she has $2,500 in interest and dividend income this year. Since she's
over the limit, interest will be imputed but will total no more than
her investment income.

In this example, only $2,500 worth of interest income would be imputed
to Joe, the lender. (Ann has $2,500 of investment income, so that's the
maximum for imputed interest.)

That's true even if Ann pays no interest on the loan and the foregone
interest, based on the AFR, is $4,090, or 4.09% of $100,000.

Trap: If loans to a given borrower total more than the $100,000
exception even by a few dollars, the exception won't apply. On a
$110,000 loan, for example, all the foregone interest would have to be
added to Joe's taxable income.

Key: The amount of interest income that's imputed to the lender can be
deducted by the borrower, if the requirements for deducting interest
are met.

GAUGING THE GIFT TAX

The two exceptions noted above (for loans of up to $10,000 and
$100,000) relate to income tax consequences, not to gift tax
consequences. The foregone interest on a below-market loan is treated
as a gift. Fortunately, the annual gift tax exclusion applies to such
gifts.

Current level. Everyone can give up to $12,000 per person in 2006 to
any number of recipients. (The dollar limit may be adjusted for
inflation in the future.) With interest rates at current levels, this
exclusion might eliminate the need to pay gift tax.

Example: As above, if no interest were paid on a $200,000 loan that was
made when the AFR was 4.09%, the imputed interest would be $8,180 per
year. If no other gifts were made by the lender to the borrower, the
$12,000 exclusion would cover all the foregone interest.

Result: No gift tax need be paid.

Trap: If the lender makes gifts to the borrower that year of $12,000,
besides making the loan, the foregone interest would not be fully
covered by the exclusion -- creating a taxable gift.

SAVVY STRATEGIES

The lower the level of interest rates, the less painful the tax
consequences of making a below-market loan to your child. Nevertheless,
certain steps can avoid tax traps...

Formalize the loan. Both parties should sign an agreement spelling out
the terms of the loan, and those terms should be followed.
Trap: Without a formal loan agreement, the IRS may recast the entire
transaction as a gift, which could require a substantial payment of
gift tax.

Observe the exceptions. If possible, try to keep loans below the
$10,000 and $100,000 levels, as explained above. Avoid making loans of,
say, $10,500 or $110,000.
Key: If you are lending your child between $10,000 and $100,000, keep
the child's investment income down. The child might invest any surplus
cash in growth stocks (many of which pay little or no dividends),
rather than in bank CDs or bonds.

Consider demand loans. A loan that is payable in full at any time,
rather than after a certain number of years, is a demand loan. Such
loans are considered short-term by the IRS so the interest rates may be
lower.
In April 2005, for example, when the midterm AFR was 4.09%, the
short-term rate was only 3.35%. On a $200,000 loan with no interest
paid currently, the foregone interest imputed as income to the lender
would be only $6,700 per year, instead of $8,180.


--------------------------------------------------------------------------------

--------------------------------------------------------------------------------



Tax Hotline interviewed Albert Ellentuck, Esq., CPA, counsel to the law
firm King & Nordlinger, LLP, in Arlington, Virginia. Past chairman of
the Tax Division of the American Institute of CPAs (AICPA), he writes a
monthly tax column for the AICPA publication, The Tax Adviser.