It’s natural for families to help each other out, sharing their good fortune with those they love. So, what if a child or grandchild wants to purchase a home or car and needs some help? Should you gift them the money, or is a loan the better option? There may be business, personal or financial reasons to choose either of these methods. However, below we look at the question from a tax perspective, exploring these two common ways to financially lend a hand to members of your own family.
Why Is Gifting Money to Family Members an Attractive Option Right Now?
The answer to this question has to do with the passing of the Tax Cuts and Jobs Act of 2017. The Act raised the federal estate tax exemption/lifetime gift tax exemption to new heights and is adjusted for inflation each year through 2026. As of 2022, an individual can gift $12.06 million throughout their lifetime tax free. Annually, individuals can gift up to $16,000, as of 2022, without chipping away at any of their lifetime exemption. With such generous exemption amounts, the need for loans between family members isn’t as prevalent as even a few years ago, with many opting to gift money instead of offering up a loan.
However, this seemingly clear-cut option could change in the next few years. The $12.06 million lifetime exemption will be cut in half at the beginning of 2026, and, if new tax legislation is passed, that amount could become effective even sooner.
What You Need to Know When Loaning Money to a Family Member
Some family members may decide to loan money to one another or make loans between related trusts or to an estate. There are a few reasons for this. Those giving the loan may want to teach an older child about adhering to a payment schedule with interest rates. Loaning money can also be an easy way for the lending individual to earn additional interest income, or, in the case of loans between trusts, to freeze growth and transfer appreciation. For the person receiving the loan, they can bypass closing costs and expenses associated with a bank loan, or, if they have poor credit, can help obtain what they want without being turned down by financial institutions.
Regardless of which side you are on, the flow of money must be monitored carefully. If making a loan within the family is not handled properly, the IRS could consider the transaction a gift versus a loan. While gifting is generally a great idea if structured properly, it could lead to very different tax consequences — particularly if the person loaning the money has used up their lifetime exemption amount, which then would result in a 40% tax on the gift.
Structure is Key for Family Loans
Intra-family loans must:
- Be made and carried out in good faith,
- Should include a signed written agreement with an interest rate and a fixed schedule for repayment, and
- Have a solvent borrower who intends to repay the debt.
While families may be inclined not to charge an interest rate, establishing one is actually very important in the eyes of the IRS. Section 7872 of the tax code governs loans, including family loans, where the interest rate is insufficient — meaning at a rate lower than the applicable federal rate (AFR). Specifically, an interest rate of at least the AFR must be used on loans to an individual that exceed $10,000 or there could be taxable events for the parties involved.
The AFR is published monthly on the IRS website, but, since the rate is constantly changing, you must also use caution when attempting to refinance loans. Refinancing a family loan too many times could raise the question of whether or not the loan is a bona fide debt. A good practice when refinancing a loan is to pay down some principal or otherwise provide the lender some consideration in return for the lender agreeing to refinance at the lower interest rate.
Forgiveness Can Be a Gift
Intra-family loans, including the interest or the loan in full or in part, can be forgiven. When a loan is forgiven, it does not mean the borrower must consider it as discharge of indebtedness income. The forgiven loan will not be considered as such if the borrower is insolvent or the lender forgives or cancels the loan. Instead, it will be considered a gift from the lender. IRS Code Section 102 excludes gifts from the definition of gross income. On the other side, the forgiveness or cancellation of an intra-family debt does not mean that the lender must recognize the unpaid interest. Be careful not to forgive accrued interest each year, or the IRS will look at the original loan as a gift versus a bona fide loan.
Gifting or loaning money to family members can be very nice way to “pay it forward.” Just ensure you are paying, and receiving, the funds in compliance with IRS guidelines to help ensure the effort is well worth it for all involved.
Contact Nicki Rococi at nrococi@cohencpa.com or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circ*mstances and current law.
