During the COVID-19 crisis, you may want to loan money to a family member in need of financial assistance. However, before writing out a check, you should review the federal tax rules to ensure that you’re making a tax-smart loan. The good news is that now is generally an advantageous time to lend money to family members.
Get Your Loan in Writing
Regardless of the interest rate you intend to charge (if any) on a loan to a family member, you want to be able to prove that you intended the transaction to be a loan, rather than an outright gift. That way, if the loan goes bad, you can claim a non-business bad debt deduction on your personal federal income tax return for the year the loan becomes worthless.
Losses from non-business bad debts are classified as short-term capital losses. Capital losses are valuable because they can offset capital gains and potentially up to $3,000 of income from other sources, or up to $1,500 if you use married filing separate status.
Without a written document, if you get audited, the IRS will probably characterize your intended loan as a gift. Then, if the loan goes bad, you won’t be able to claim a non-business bad debt loss deduction. In fact, you won’t be able to deduct anything, because ill-advised gifts don’t result in deductible losses. To avoid this problem, document your loan with a written promissory note that includes the following details:
The interest rate, if any,
A schedule showing dates and amounts for interest and principal payments, and
The security or collateral for the loan, if any.
Also document why it seemed reasonable to think you’d be repaid at the time you made the loan. That way, if the loan goes bad, you have evidence that you always intended for the transaction to be a loan. Your tax advisor can help you put together appropriate documentation.
What’s an Appropriate Interest Rate to Charge?Most loans to family members are so-called “below-market” loans in tax terminology. Below-market means a loan that charges no interest or a rate below the applicable federal rate (AFR).
AFRs are the minimum interest rates you can charge without creating unwanted tax side effects for yourself. These rates are set by the IRS, and they can potentially change every month.
You might be surprised by how low AFRs are right now. Making a family loan that charges the AFR, instead of 0%, makes sense if you want to give your relative a low interest rate without causing any unwanted tax complications for yourself.
For a term loan (one with a specified final repayment date), the relevant AFR is the rate in effect for loans of that duration for the month you make the loan. Here are the AFRs for term loans made in June and July.
AFRs for Term Loans Made in June and July 2020
June 2020 AFR
July 2020 AFR
Short-term (3 years or fewer)
Mid-term (more than 3 years but not more than 9 years)
Long-term (more than 9 years)
The same AFR continues to apply over the life of a term loan, regardless of how interest rates may fluctuate. Currently, AFRs are significantly lower than the rates charged by commercial lenders. If you charge at least the AFR on a loan to a family member, you don’t have to worry about any unexpected federal tax complications.
If you make a demand loan that you can call due at any time, instead of a term loan, the AFR for each year will be a blended rate that reflects monthly changes in short-term AFRs. That means the annual blended rate for a demand loan can change dramatically depending on general interest rate fluctuations. In contrast, making a term loan that charges the current AFR avoids any interest-rate uncertainty, because the same AFR applies for the entire life of the loan.
The federal income tax results are straightforward if your loan charges an interest rate that equals or exceeds the AFR: You must report the interest as income on your tax return. The borrower (your relative) may or may not be able to deduct the interest, depending on how the loan proceeds are used.
Important: If the loan proceeds are used to buy a home, the borrower can potentially treat the interest as deductible qualified residence interest if you secure the loan with the home. However, qualified residence interest won’t cut the borrower’s federal income tax bill unless he or she itemizes.
What Happens if You Charge an Interest Rate Below the AFR?
The tax results can get complicated if your loan charges interest at a rate that’s lower than the AFR. The interest on a below-market family loan is treated as an imputed gift to the borrower for federal tax purposes. The value of the imputed gift equals the difference between the AFR interest you should have charged and the interest rate you actually charged (if any).
The borrower is then deemed to pay this amount back to you as imputed interest income. Though no cash is exchanged for imputed interest, imputed interest income must be reported on your federal income tax return. But with today’s low AFRs, the imputed interest income and the related tax hit will be negligible or nearly negligible — unless you make a large loan.
Some family loans may be eligible for the following two taxpayer friendly, imputed-interest loopholes:
1. The $10,000 Loophole. For below-market loans of $10,000 or less, the IRS lets you ignore the imputed gift and imputed interest income rules. To qualify for this loophole, all outstanding loans between you and the borrower must aggregate to $10,000 or less. In that case, you can charge an interest rate below the AFR, and there won’t be any federal tax consequences — even if you charge no interest.
Important: You can’t take advantage of the $10,000 loophole if the borrower uses the loan proceeds to buy or carry income-producing assets.
2. The $100,000 Loophole. With a larger below-market loan, the $100,000 loophole can save you from unwanted tax results. To qualify for this loophole, all outstanding loans between you and the borrower must aggregate to $100,000 or less.
Under this loophole, if the borrower’s net investment income for the year is no more than $1,000, your taxable imputed interest income is zero. If the borrower’s net investment income exceeds $1,000, your taxable imputed interest income for the year is limited to the lower of:
The borrower’s actual net investment income, or
The imputed interest income amount.
With today’s low AFRs, the imputed interest income amount and the related federal income tax hit will be negligible (or close to negligible) even on a $100,000 loan that charges 0% interest.
The federal gift tax consequences under the $100,000 loophole are tricky. But with today’s low AFRs and generous unified federal gift and estate tax exemption, these rules probably won’t matter much (if at all) for a below-market loan of up to $100,000.
The amount of the imputed gift won’t be very large, and the unified federal gift and estate tax exemption for 2020 is $11.58 million, or effectively $23.16 million for a married couple. This generous exemption translates into a small chance of any meaningful gift tax consequences from making a below-market loan of up to $100,000, even if you charge 0% interest.
Your tax advisor can help make imputed interest calculations on below-market loans to determine what’s right for your situation. However, below-market loans made right now — while AFRs are low and the unified federal gift and estate tax exemption is generous — probably won’t make any meaningful difference to your tax situation. That said, AFRs usually change every month, so the tax results from making a below-market loan can be a moving target.