Strategy: Give your child a low-interest, or even a no-interest, loan. If you stay within the tax-law boundaries, your family will have no tax worries. However, if you’re not careful, you could wind up facing an unfavorable tax outcome.
With interest rates remaining on the low side, this is a good time (from a gift-tax perspective) for a loan.
Here’s the whole story: The tax law frowns on intrafamily loans in which you don’t charge any interest or you charge interest at a below-market rate.
Under the below-market loan rules, interest may be imputed under a three-step process:
1. You are deemed to charge imaginary interest to the borrower.
2. You are deemed to make a gift to the borrower to cover the imaginary interest.
3. You are deemed to receive imaginary interest income from the borrower.
In other words, you’re stuck with a tax bill on interest income, even though you never actually receive a penny of interest. Tax practitioners refer to this as “phantom income.”
Here are two ways to avoid this harsh tax result for intrafamily loans:
1. Keep the loan amount below $10,000. Loans totaling $10,000 or less fall under a di minimis exception and are exempted from the below market loan rules.
2. Keep the loan amount below $100,000. For loans totaling $100,000 or less, the IRS limits the interest amount you’re treated as receiving annually for tax purposes to the borrower’s net investment income for the year. And, if the borrower’s net investment income doesn’t exceed $1,000, there’s no taxable interest income on the intrafamily loan.
Example: You make a $90,000 interest-free loan to your child on July 1 when the Applicable Federal Rate is 3%. For 2008, your net investment income is $1,000. On Dec. 31, you normally would be treated as having received $1,350 in interest. However, because of the net investment income rule, your taxable interest is limited to $1,000.
This special exception does not apply if you’re using a below-market-level interest rate with a principle purpose of tax avoidance.
Tax-smart alternative: Rather than give your child a low-interest or no-interest loan, charge the child the minimum IRS-approved interest rate. In addition, spell out in writing the key elements of the loan agreement, including the amount, the time for repayment and the designation of collateral.
Finally, have the loan document witnessed and notarized.
You’ll have proof on your side if the IRS challenges the transaction. Make sure you dot all the i’s and cross all the t’s.
What happens if your child can’t repay the loan? For a personal loan, treat it as a short-term capital loss when the loan becomes totally worthless (i.e., there’s no reasonable prospect for repayment). So, you can use the loss to offset capital gains realized during the year, plus up to $3,000 of ordinary income.
Tip: If you make the loan in connection with your business, the full amount of the loss may be used to offset highly taxed ordinary income (e.g., your salary).
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