The low-interest or interest-free family loan is one of the best strategies to protect yourself against the numerous planned increases in income and inheritance tax and to benefit from the current low interest rates.
A family loan reduces income and inheritance taxes under applicable law, but is also flexible so it can be adapted to many likely changes in the tax code. A family loan offers more than just tax benefits. It offers immediate help to children or grandchildren instead of keeping them waiting to inherit.
The Federal Reserve’s zero interest rate policy is another reason why family loans are a good strategy today. The IRS requires that many loans between family members require at least a minimum interest rate to avoid negative tax consequences, and that minimum interest rate is very low today as it is based on US Treasury bond yields.
Loans between family members are common, but many people are unaware that there are specific provisions of tax law that address it. There are also established strategies to maximize the family’s after-tax wealth by using the loans.
If no interest rate or an interest rate below the minimum rate set by the IRS is charged on an inter-family loan, the tax law charges an interest rate equal to the IRS minimum rate.
The lender must report interest income at the minimum rate set by the IRS even though no cash is received. The borrower may be able to deduct the same amount as mortgage interest or business interest if the conditions are met.
In addition, it is assumed that the lender will give the borrower the imputed interest if the loan is made among family members. In most cases, the annual gift tax exclusion is more than enough to avoid the tax consequences of the gift. In 2021, an individual can give up to $ 15,000 per person with no gift tax consequences under the annual gift tax exclusion. A married couple can donate up to $ 30,000 together.
In order to avoid the imputed interest, a written loan agreement should be available in which the loan amount, the interest rate and the repayment conditions are specified. You can find simple loan agreement forms on the Internet.
The interest rate should be at least the minimum interest rate set by the IRS for the month the contract is signed. You can find the minimum interest rate for the month by searching the Internet for “applicable federal interest rate” for the month in which the loan agreement was concluded. The interest rate depends on whether the loan is short, medium or long term and whether the interest is paid monthly, quarterly, semi-annually or annually. If the loan is in a significant amount, it is a good idea to consult a tax advisor or estate planner to make sure that the correct interest rate is being calculated.
There are two important exceptions to the imputed interest rules.
A loan of $ 10,000 or less is excluded. Get a relatively small loan and the IRS won’t take care of it.
The second exception is for loans of $ 100,000 or less. Imputed income rules apply, but the lender may declare imputed interest at the lower of the applicable federal rate or the borrower’s net asset income for the year. If the borrower does not have much investment income, this exemption can significantly reduce the amount of reported imputed income.
If the loan agreement provides for regular payment of interest or interest and principal, these payments should be made and documented. The more you make the transaction look like a real loan, the less likely the IRS will attempt to tax it as something else, such as B. as a gift.
A written loan agreement can also help prevent misunderstandings between the borrower and your estate or other family members.
Suppose Hi Profits, son of Max and Rosie Profits, wants to buy a house and needs help with the down payment. Max and Rosie borrow $ 100,000 Hi. They charge 2.15% interest on the loan, which corresponds to the federal rate applicable in May 2021 for a long-term loan, in which the interest is compounded every six months.
Regular interest payments are not required under the loan agreement and Hi does not make any. Max and Rosie will have an assumed income of $ 2,150 each year that must be included in their gross income. Additionally, they will be treated like they are giving Hi to $ 2,150 each year. As long as you don’t give Hi any other gifts in addition to the annual gift tax exclusion (US $ 30,000 for gifts shared by a married couple), there are no gift tax consequences.
Hi can have the loan booked as a second mortgage against the property. This could allow him to deduct the imputed interest from his income tax return even though he has not made any cash payments.
Max and Rosie have two costs on the loan. The first cost is the investment income they could have made on the $ 100,000.
The other cost is the income taxes they owe on the imputed interest income.
The family loan is now a particularly good strategy.
As has been the case for several years, very low interest rates enable an adult child or grandchild to invest the loan proceeds and earn more than the interest paid on the loan.
One strategy is for the borrower to invest the money for a few years, repay the principal and interest to the lender, and pocket the excess income. This is also a way for the lender, who is likely to be in a higher tax bracket, to lower family income tax by taxing the income or profits with the borrower.
Another strategy is longer term. A parent or grandparent grants a loan with terms that do not require payments for years. After a period of time, the lender will grant the loan and interest and convert it into a gift.
Some people plan to cancel the debt once they are sure that the borrower is not wasting the money. Others plan to include lending in their wills and estate plans.
The ability to forgive is particularly important as the inheritance and gift tax law could change.
Suppose you are making money or property to an adult child today. If the lifelong inheritance and gift tax exemption is reduced, or is likely to be reduced later this year or next, making your estate taxable, signing a loan waiver document is an easy step to use for the gift falls below the current high tax allowance instead of the new, lower tax allowance.
A low tax base home loan can also be a good strategy. One recent proposal is to remove the ability for heirs to raise the tax base of inherited wealth to its current market value, known as the step-up-in basis. Instead, the estate would owe capital gains taxes on the increase in value that occurred during the deceased owner’s holding period.
For example, suppose you are giving a grown child a gift that will be greatly appreciated while you have possessed it. If the top-up base is no longer available, you can cancel the loan and convert the loan into a gift of the share to the child.
This has at least two advantages. One benefit is that the child may be in a lower capital gains tax bracket than you or your estate, which reduces the tax burden compared to holding the shares in your estate.
Another benefit is that the child can sell the stock if they want. It can be phased out over the years or if it would minimize taxes. If you continue to own the stock, taxes will be due shortly after your death.
You don’t have to cancel the loan if the tax law doesn’t change or the changes don’t affect you. The borrower can repay the loan by returning the money or property to you.
If you intend to take out any outstanding family loans upon your death, be sure to include this in your will. It is common practice to state the details of the loans in a will or an annex and that they will be waived after the lender’s death. If the lender desires equal treatment for all family members, the will should also state that the amount inherited from the debtor is reduced by the amount of the waived loan.
Family loans are widespread, and there are reasons why they should be used more widely today. Make sure you take the extra steps necessary to avoid problems with the IRS and to maximize after-tax family wealth.