IRS Laws and Loans Between Relatives

Loans between relatives weren’t always the concern of the Internal Revenue Service (IRS). Families could loan money to other members in need without consequence. Then, according to USA Today, taxpayers in higher tax brackets started loaning money to family members with lesser means and those members invested the cash successfully resulting in gains taxed at a lower rate in an attempt to evade taxes. The IRS now has rules for loans between relatives.

Interest Issues

The IRS requires all loans of more than $10,000 be reported on your tax returns. In addition to reporting them, you must also have some sort of promissory note and charge interest. The money being lent isn’t in danger of being taxed but the interest it earns is subject to taxation. The IRS assumes lenders receive interest income from the loan and tax that income at the current imputed interest rate regardless of what interest the parties agreed to. Sometimes the absence of interest causes the IRS to consider the loan a gift and thus, gift taxes apply.

Promissory Note

The contract or promissory note is necessary to not only outline the terms of the agreement, but also to prove to the IRS that a loan is legitimate. The document is also evidence of the loan. In the event of a loan default, the document evidences the loss and the canceled debt becomes income for the borrower. A well-documented loan may also become a non-business debt deduction.

Investment Hurdle

If the loan is less than $100,000, the imputed interest rate may apply if the borrower has less than $1,000 in investment income for the same tax period. The IRS does compute an imputed interest amount, but only charges it if the borrower meets the investment income limit. If the loan exceeds $100,000, then the interest income is taxable no matter what. Borrowers with more than $1,000 in interest income will cost the lender the lesser of the imputed interest or actual investment income.

References

• Smart Money; Loans Among Family Members
• USA Today; Follow Simple Rules to Avoid Letting Loans To Relatives Cause a Family Rift
• MSN Money Central; The Right Way to Loan Money to Family Members