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Intrafamily Loans: Know What You're Getting Into
March 16, 2010
When money is tight, and particularly when job losses affect an extended family, the prospect of an intrafamily loan often comes up. After all, why go to an impersonal bank when a family member is only a phone call away? Yet, if not conducted carefully, these arrangements can lead to awkwardness, if not outright conflicts. There also may be tax implications. Here are some things to bear in mind before making an intrafamily loan.
What are we really doing?
The first thing to consider when the prospect of a loan comes up is whether you’re truly discussing a loan. If, deep down, you know that, should push come to shove, you wouldn’t seriously pursue the loved one should he or she fail to pay back the money, you’re likely better off gifting the money — or simply refusing. Keep in mind that many family conflicts arise from failure to repay loans, which can lead to awkwardness at best and estrangement at worst.
If you do decide to move forward with an intrafamily loan, formalize the arrangement as much as you can. This should include a signed, written document that spells out the loan’s terms and a repayment schedule. By formalizing the transaction, you’ll clarify the expectations of both parties, as well as help avoid negative tax consequences.
In addition, you’ll have the necessary documentation to support a bad-debt deduction in the event the family member defaults.
How can I be sure?
To avoid unforeseen tax consequences, it’s important to structure a family loan properly. The IRS tends to look for several indicators to verify a loan’s authenticity. One is a written agreement and repayment schedule. The IRS also examines whether the borrower executes a promissory note and sticks to the repayment schedule.
Among the most significant factors to the IRS, however, is whether appropriate interest is charged. You should generally calculate interest according to the applicable federal rate (AFR). Any loan in which the borrower is charged less than the AFR at the time the loan is made is considered “below market” and, if challenged, will likely trigger both income and gift tax consequences. Even if you meet all the general criteria for a loan, the IRS could still recharacterize an otherwise bona fide loan as a taxable gift if it believes the money was lent only for tax-saving purposes.
Who can help?
As you can see, intrafamily loans pose a risk in terms of both family relationships and tax liability. Although your tax advisor probably can’t assist with the former, he or she can help you structure an intrafamily loan that will stand a good chance of avoiding trouble with Uncle Sam.
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