How to make tax-savvy loans with family, friends, and loved ones.
This article was written purely for educational purposes, this does not constitute legal, or financial advice. Consult your lawyer, tax, or financial advisor before making any decisions based on the information you’ve read in this post. The tips outlined below are applicable to the United States, Internal Revenue Service.
Everything we do seems to have some tax implications. Loans between family, friends, or loved ones are no different. If you are thinking about lending your friend money to help them buy their first car you might want to read this article before charging a 0 percent interest rate on that loan. We have experience making informal & unsecured loans, so we have compiled some tips you should think about before making your next loan.
1. The $10,000 USD Rule (AKA the De Minimis Exception)
This is the magic number. The IRS will consider a loan that is smaller than $10,000 USD as a “small” loan as long as the Borrower doesn’t use any of the money from the loan to generate additional income. Generally speaking, “small” loans will be subject to less scrutiny from the IRS, and the following rules that we outline in this article will likely not apply to them. So, if you want to lend money to loved ones, keeping it below $10,000 will help avoid tax complications and IRS headaches.
Straight from the source; check out the US Tax Code 26 USC § 7872.
2. Charge an Interest Rate Equal to or Above the Applicable Federal Rate.
Things get a little trickier when creating loans larger than $10,000 USD. At this point, loans above this amount are no longer considered “small” by the IRS. Above the $10,000 USD threshold, you want to make sure you are structuring your loan properly. One way to do this is to charge an interest rate on your loan that is equal to, or larger than the IRS-approved applicable federal rate (AFR) set during the month in which your loan agreement started. It gets a little complicated so we’ve broken it down below:
- What is the AFR and which rate do I choose for my preferred interest?
Every month, the US government establishes a list of minimum interest rates for debt instruments. Based on the context of the US economy at that time, these predetermined rates are meant to reflect a fair market rate.
AFRs are broken down into short, mid, and long term rates, so you should pick the rates that align best with the term length of your intended loan. Short term rates should be used when making a loan that will be repaid in three years or less. Mid term rates should be used when making a loan that will last between three to nine years long. Long term rates should be referenced for loan agreements that will be longer than nine years total.
Straight from the Source. Monthly Applicable Federal Rates (AFRs) can be found here.
It is important to note that while AFRs are changed monthly, the only rate that is applicable to your loan is the rate of interest that is set during the month your loan agreement is signed. For example, if in August, the mid term AFR interest rate is 0.41%, and in August you agree to loan Becky $15,000 USD over 4 years, she should owe you at least a 0.41% interest rate on that loan term.
- Why is charging an interest rate a good idea from the Lender’s perspective?
If your loan exceeds $10,000 USD, then the IRS will expect you to have an interest rate, regardless of whether you actually have one in place. As the Lender, the IRS could end up taxing you on an interest rate that you could have charged but did not, also known as “imputed interest”. By taxing the Lender on an interest rate they did not collect, the Lender would end up unnecessarily losing money with their loan.
- Why is paying an interest rate a good idea from the Borrower’s perspective?
Making a loan in which you do not pay an interest rate, or you pay an interest rate below the respective AFR, would categorize your loan as a “Gift Loan” or “Below-Market Loan”. As a result of your actions, the IRS will calculate the difference between the AFR and the interest rate you charged, apply that to your loan, and consider this discrepancy in funds a “gift” from the Lender to the Borrower. “Gifts” can then be taxed, and the Lender will have to pay the applicable tax rate. If however, you apply at least the respective AFR to your loan, you will not have to worry about this headache.
Straight from the Source. Gift Tax Guidance can be found here.
3. For Any Loan, Have the Appropriate Documentation
This is the most important action you can take to avoid getting into tax trouble. Regardless of the size of your loan, you will want to have a comprehensive loan agreement, agreed upon and signed by both parties, as well as proper documentation of your timely payments. This is important not only because you have to be able to prove you have a high enough interest rate, but also because if you forgive the loan, you might have to prove that the loan forgiveness was not planned from the start.
Of course, the IRS knows that loan forgiveness can happen, but it will only allow for loan forgiveness as long as it is proven to be unexpected. In other words, the IRS does not want you to give Becky $30,000 USD as a present and avoid gift taxes by making a loan which you will forgive anyways.
Having a legally signed loan agreement, as well as documentation of your payments, is a great way to show that the loan was legitimate. Luckily, Pigeon makes it very easy for you to get a signed agreement that will help steer you clear of tax trouble.
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