Family members have an inherent desire to help one another achieve their dreams, whether it’s buying a home or starting a business. They may also feel compelled to provide assistance in times of need, such as with medical expenses and education expenses, or during periods of unemployment. While it’s common for family members to step in with financial aid, the tax implications of these transactions may get overlooked. Understanding the complexities of intrafamily loans and gifts is crucial for making informed decisions about wealth transfer strategies, as is knowing the tax laws that could influence these decisions.
Gift tax rules: What are they?
The lifetime estate and gift tax exemption amount in 2024 is $13.61 million. This amount is almost exclusively thought of and talked about as the lifetime estate tax exemption amount, meaning that it is the maximum net worth that anyone can have at their death without being subject to estate tax. While this is partially true, the lifetime exemption amount is much more than that. It is also the lifetime gift tax exemption amount.1 This means that it’s the maximum lifetime amount that any person can give away prior to death without being subject to gift tax.
In addition to the lifetime exemption amount, there is an annual exclusion amount of $18,000 for gifts. The significance of annual exclusion gifts is that they are not only non-taxable, but also non-reportable. If someone makes a gift of $1 million, it will be tax-free since it is within the $13.61 million lifetime exemption. However, it would have to be reported to the IRS on a gift tax return and it would also count against the donor’s lifetime exemption amount. If a gift is within the $18,000 annual exclusion limit, then the gift does not need to be reported at all, and it does not count against the donor’s lifetime exemption amount. Amounts paid directly to an educational institution or healthcare provider on behalf of another person also are not counted against the lifetime exemption.
Loan tax rules: Pretty straightforward
The general tax rules regarding family loans are relatively straightforward. The lender will report interest income on any interest received, and the borrower may be entitled to a deduction if the interest on the loan is deductible under applicable tax rules. For example, if the loan interest represents a qualified business expense or mortgage interest, it would be deductible just as if the borrower had borrowed from a traditional commercial lender.
However, many intrafamily loans are not structured the same way as a typical third-party loan. Intrafamily arrangements may be less formal, with more generous repayment terms, and minimal or no collateral. This is where tax problems can arise. To avoid potential problems, loans should be documented and treated for all purposes as bona fide debt that will be repaid.
If money is loaned to a family member with no real intention that it will be repaid, then the IRS can recharacterize the transaction as a gift. This would require the lender to file a gift tax return and use part of their lifetime exemption, if the loan amount exceeded the $18,000 annual exclusion limit. To avoid this result, all loans should be memorialized with a promissory note.
For more complicated arrangements, such as loans secured by real estate or other property, an attorney should be consulted to ensure that all applicable requirements are met.
Below-market loan tax rules: More complicated
Potential tax problems arise if a loan is what the IRS calls a “below-market” loan. A below-market loan is a financial arrangement where interest on the loan is below what the IRS considers adequate. Section 7872 of the tax code addresses the treatment of loans with below-market interest rates for federal tax purposes.3 The foregone interest in a below-market loan has both income tax and gift tax consequences for the lender. The lender will be taxed on the imputed interest income and will be deemed to have made a gift to the borrower based on the below-market interest.
Unfortunately, determining whether a loan is below-market is not always as simple as whether the loan interest rate is lower than the applicable federal rate (AFR). Rules for below-market loans are incredibly complex.
Basically, there are two types of loans: demand loans and term loans. Different methodologies and rules apply in determining whether each of loan is a below-market loan.
- Demand loan: Must be repaid on demand; no specified time period.
- The short-term AFR with semiannual compounding is the minimum interest rate.
- Term loan: Must be repaid within the specific time period noted in the loan document.
- The AFR is not necessarily the minimum interest rate; a present value calculation is required to determine whether a term loan is a below-market loan.
As a practical matter, demand loans are generally easier to deal with than term loans from a tax standpoint, primarily because their tax consequences can be more easily determined with reference to the AFR.
To complicate matters even more, there are exclusions to the below-market loan rules. Loans of $10,000 or less (taken together between a specific lender and specific borrower) are exempt from the rules altogether. Loans of more than $10,000, but not more than $100,000, may have reduced income tax consequences.
An effective way to help avoid the complexity and potential tax consequences of below-market loans is to simply charge adequate interest.
Takeaways
In navigating family loans and gifts, the key is to understand the tax implications and plan accordingly. Charging adequate interest and documenting loans properly can help avoid potential tax pitfalls. Remember, seeking advice from a tax professional is always a smart move to help ensure you’re making informed decisions.
When it comes to supporting family members financially, understanding the tax implications is crucial. Whether you’re considering a loan or a gift, knowing the rules and seeking professional guidance can help you make the right choices for your loved ones while staying in the clear with the IRS.
Contact your advisor if you have questions about an existing or potentially upcoming loan or gift for a family member. If you’re not a Mercer Advisors client and want to know more about how we can help with navigating the complexities of intrafamily gifts and loans, let’s talk.
1. While generating-skipping transfer (GSTT) is beyond the scope of this article, it should be noted that the same lifetime exemption amount that applies to the estate and gift tax is also shared by the GSTT. This allows a transfer to a grandchild, for example, to not only be tax free for gift tax purposes if within the lifetime exemption amount, but also to be free from GSTT if within that same limit. This also allows transfers to certain trust to not only use the lifetime gift exemption to avoid payment of gift tax on lifetime gifts up to the exemption amount, but also to allocate GSTT exemption to the gift so that the trust will not be subject to GSTT when it makes distributions to grandchildren or more remote beneficiaries in the future.
2. Applicable Federal Rates Rulings, IRS.gov.
3. Sec. 7872. Treatment Of Loans With Below-Market Interest Rates, Bloomberg Tax.
