Dispel ‘phantom income’ on family loans

Suppose your adult child needs a helping hand to launch a new business or buy a home.

Strategy: Give the child a low- or even no- interest loan. As long as you stay within the tax law boundaries, your family will have no tax worries. However, if you’re not careful, you could be blindsided by an unexpected tax bill.

With low interest rates, this may be a good time to arrange a loan from a gift tax perspective.

Here’s the whole story: The tax law discourages intrafamily loans where you don’t charge any interest or you charge interest at a below-market rate. In brief, interest income may be imputed to the lender under the following sequence:

  • You’re treated as having charged interest to the borrower.
  • You’re treated as having made a gift of the interest to the borrower.
  • The borrower is treated as having used the gift to pay the interest to you.
  • You must report the deemed interest on your tax return.

In other words, you’re hit with a tax bill on interest income, even though you never actually receive one thin dime in interest. Tax practitioners often call this “phantom income.” There are two ways to avoid this harsh tax result.

HR Forms D

1. Lend less than $10,000. There’s a “di minimis exception” in the law for loans to one borrower that total $10,000 or less as long as the loan proceeds are not used to purchase or carry income-producing assets.

2. Lend less than $100,000. For loans totaling $100,000 or less, the amount of interest you’re treated as receiving annually for tax purposes is limited to the borrower’s net investment income for the year. If the borrower’s net investment income doesn’t exceed $1,000, there’s no taxable interest income on the intrafamily loan.

Note that this special exception does not apply if you are charging a below market level interest rate for tax avoidance purposes.

The IRS can be especially tough on loans reputedly made for business purposes. If you can’t present clear and convincing evidence that the loan is tied to a business transaction, it may be deemed to be a gift. In that case, you’re not entitled to any tax benefits if the loan isn’t repaid.

Instead of giving your child a no-interest loan, you might charge the child interest based on the Applicable Federal Rate (AFR) for the month of the loan. (The AFR for long-term loans of more than nine years made in April 2014 was only 3.28%.) Also, 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.

If your child can’t repay a personal loan, the subsequent loss is treated as a short-term capital loss when it becomes totally worthless (i.e., there’s no reasonable prospect for repayment).

Tip: For a loan made in connection with your business, the full amount of the loss may offset highly taxed ordinary income (e.g., salary).