How to Make a Tax-Friendly Family Personal Loan
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UPDATED: Aug 13, 2012
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Family personal loans are commonplace amongst parents and children, with parents often loaning money to their kids for first-time auto or electronic purchases. Given the sluggish economy though, they’re growing amongst other familial relationships as well. But after loaning money out to family members, the lending party sometimes finds themselves with unexpected charges come the tax season. Had the family personal loans been structured to be tax-friendly, both lender and borrower would avoid unnecessary taxes on inter-family loans.
Family Personal Loan Mistake #1: Charging No Interest
When lending money to family members, a common approach is to lend without interest. After all, what better way to help out a dependable family member than charging no interest on a substantial amount of money? While this benevolent move may help the borrower, in the long run it will hurt the lender.
If you make a zero interest personal loan to anybody, the Internal Revenue Service—better known as the IRS—will slam you with a below-market interest tax.
Below-market interest taxes (also called imputed interest rules) were developed to dissuade wealthy individuals from loaning money to their children in lower tax-brackets at no interest, then having their children invest that money on behalf of the parents. If the IRS suspects a family member of lending money to another at zero interest, they may very well charge a below-market interest tax on the money.
A below-market interest tax is calculated by looking at the total money lent and the duration it was lent for, then calculating what the interest rate would actually be in real borrower-lender relationships. At that point, the lender will be taxed on each payment he received from the borrower.
Families can avoid below-market interest taxes by charging the minimum amount of interest required on their personal loans.
According the Wall Street Journal, the minimum amount of interest required for tax-friendly personal loans is equal to the applicable federal rate (AFR) as approved by the IRS.
The current monthly AFRs on personal loans are as follows:
- 0.25 percent for loans of up to three years
- 0.88 percent on loans between three and nine years
- 2.21 percent on all loans over nine years
But AFRs are updated monthly and can be found on the IRS’s index of AFR rulings.
Family Personal Loan Mistake #2: Not Making a Contract
Contracts amongst family members may seem silly, but, in the event the transaction turns sour, a contract may be the only thing that can save a relationship.
For any substantial amount of money lent, contracts are necessary protections for both borrower and lender. Contracts preserve any and all agreed-upon terms, and allow both parties to refer to the contents and structure of the financial arrangement they’re a part of at any time.
They also provide legal protections for the lender in the even the borrower defaults. God forbid family members fight over money, but if they do, a contract will help mitigate the relationship damage and expedite a resolution.
Additionally, contracts act as proof that a personal loan is not a gift—which brings us to our next essential point of structuring these deals.
Family Personal Loan Mistake #3: Structuring Arrangement Like a Gift
If the IRS sees a financial arrangement as a “gift” then the giver of that gift (i.e. the lender) loses all rights to reclaiming their money.
Additionally, the gift-giver is the party responsible for any IRS-imposed taxes on the gifted money, which means the lender will be hit with a tax come the end of the year—much like the below-market interest tax mentioned above.
A “gift,” according to the IRS, is any transfer of money where full consideration is not received in return. It is precisely due to this definition that a contract is absolutely necessary when creating a family personal loan. That way, if audited, a lender can prove to the IRS that the money lent was an actual loan, complete with a fair interest rate.
There’s Always Alternatives
It’s absolutely necessary to remember that no amount of money is worth ending—or even fracturing—a family relationship. Consider an alternative source of money if that’s something that either a family lender or borrower fears.
For borrowers with higher credit scores, unsecured personal loans are widely available. What’s more is that by using free online loan quote comparison tools, borrowers can quickly sift through and select a lender that will offer them the cheapest personal loan.
Those who have less-than-pristine credit scores can try finding secured financing, in which they will receive money in exchange for a piece of collateral that a lender can hold as security for their money. Security usually comes in the form of auto titles, paychecks, or home equity.