Q. My wife and I want to make a loan to our son to help him buy a home. We are really not interested in charging interest and we might even forgive the loan in our Wills. Are there any tax implications of which we should be aware?
A. Yes, there are. Concerns regarding intra-family loans of this nature often fall into two categories:
1) The Initial Loan: Imputed Interest: If you were to make an interest-free, or below-market rate, loan to your son, the IRS would presume that the loan was really a disguised gift. Gift Tax rules would then be implicated. Depending upon the amount involved, the “loan” could trigger an obligation to file a Gift Tax Return and either (a) a reduction in your remaining lifetime exemption amount, or (b) an obligation to pay a gift tax. Thus, in order to recognize this transaction as a true loan, the IRS requires that it carry a minimum interest rate. This minimum rate is called the Applicable Federal Rate (“AFR”), which is published monthly by the IRS.
To the extent the interest on your loan is below that rate, you and your wife would be deemed to have imputed income, even if you never actually receive any interest payments. Some people refer to this as phantom income. If you failed to report it on your tax return, the IRS could determine that you had underreported your income, and you might then be subject to income tax on the phantom interest and an under-reporting penalty.
However, if you structure the loan properly at the outset, you can avoid these Gift and Income Tax problems. Essentially, you would prepare a written promissory note which assigned a rate of interest to the loan at least equal to the then applicable AFR. By way of example, a $50,000 loan for a three-year term made in January, 2017, must carry an interest rate at least equal to 0.96% to comply with the AFR. If for a term of 3 to 6 years the AFR would be 1.97%, and if for a term of 9 years or longer the rate would be 2.75%. Notes payable “on demand” require use of a blended rate. Further, if the loan were secured by a recorded deed of trust on your son’s home, he may be able to claim the home-mortgage interest deduction on his own tax return.
So long as the loan were structured in this manner and the corresponding interest declared on your tax returns, you would be in good stead with the IRS. Note: There is an exception to the imputed interest rules where the total loans outstanding to your son do not exceed $10,000, and a qualified exemption for loans between $10,000 and $100,000.
(2) Loan Forgiveness; Recognition of Income: Sometimes parents provide in their wills or trust that loans to their children are to be forgiven upon the parents’ demise. The question that arises in this context is whether the debt forgiveness results in the recognition of income to the child under the “Cancellation of Debt” (“COD”) rule. Good news: generally speaking, amounts cancelled as a result of bequests or inheritances are exceptions to the recognition of income rule, and loan forgiveness in this context would usually not result in the recognition of taxable income to the child. Another option: use your Annual Exclusion Amount ($14,000/person/year in 2017) to partially forgive his debt each year. Same result, over time.
These rules are complex. Anyone considering debt forgiveness would be well advised to seek professional advice as part of one’s planning.
References: Internal Revenue Code § 1274(d) [Determination of Applicable Federal Rate]; IRC § 7872 [Treatment Of Loans With Below-Market Interest Rates]; IRS Publication 4681 [Cancelled Debts @ page 4]; Rev.Rul. 2017-2 [AFR’s for January 2017]; Rev.Rul. 2017-07 [AFR’s For March, 2017]; Historical Index of Applicable Federal Rates. Note: The AFR “Short Term” rate is for loans of 3 years or less (or demand loans); “Mid-Term” rates are for loans of 3 years to 9 years, and “Long Term” rates are for loans for a term of more than 9 years.