In other words, you lend a loved one over $10,000, and never charge or collect a penny of interest income on the family loan, the IRS requires you to pay income taxes on the earned interest income the IRS believes you should have received, based on the AFR at the time the loan was made. See IRC Sec. 7872(a) & 7872(e) & 7872(f)(2)
In addition to holding the Lender responsible for the taxable imputed interest, the IRS also assumes that since the Borrower did not make the required interest payments, the Lender is considered to have gifted the Borrower the money to pay the interest that was due. See IRC Sec. 7872(f)(3)
The IRS doesn’t want us making substantial, interest free loans to our family members. The IRS wants to tax us on required interest income on legitimate loans.
By engaging in a loan with a family member below the appropriate AFR, the Lender is effectively penalized twice — once through taxation of imputed interest, and again by applying the borrower’s unpaid interest towards the lender’s annual $17,000 per person tax-free gift limit.
The IRS’ annual gift exclusion permits a taxpayer to gift up to $17,000 annually to each and every family member without penalty. Effectively, an individual could gift $17,000 to everyone they know, but once any one gift recipient receives a penny more than $17,000 from an individual donor in the calendar year, that donor must file a gift tax return. See IRS Publication 559
A poorly documented loan that the IRS considers a gift could also have significant effects on the Lender’s life-time gift and estate tax exemptions. Likewise, if the Borrower is unable to repay the loan and the Lender wishes to deduct the loss from their income taxes, documentation showing that the loan was legitimate could be critical.
Proper family loan documentation can also help avoid serious legal disputes with other family members (especially between siblings) or estate and repayment complications following an unexpected divorce or untimely death.
If a family loan is being used to specifically help purchase or refinance a home, the Borrower and Lender should consider the advantages of securing the loan through a properly registered Mortgage, Deed of Trust, or Security Deed.
In most cases, by securing a family loan through a properly registered Mortgage Deed of Trust, or Security Deed, the Borrower will be legally entitled to deduct the interest paid on the loan from their taxes at the end of the year. In order to legally exercise the deduction, the loan must be secured through a registered Mortgage, Deed of Trust, or Security Deed and properly filed with the appropriate government authority. See IRS Publication 936 or IRC 1.163-10T(o)
As always, we strongly encourage all families to discuss their individual financial strategies and potential estate planning and tax considerations with their trusted attorney, financial advisor, or tax advisor.
