In today’s lending environment, it can still be difficult to qualify for a loan, especially with favorable terms. As a result, many individuals looking to buy a home or a car are turning to family members for financing. For a family member with means, this presents an interesting opportunity to help a loved one and earn an interest rate that is likely more than the paltry interest rate they are earning on their cash.
Before writing the check, there are a number of things to consider.
1) Should you even make the loan at all? Mixing family and finances can be dicey. As the lender, you should be sure that you are comfortable loaning the money, and never loan more than you are able to lose. It is not worth putting your own financial situation at risk to help out a family member. As a borrower, it is also important understand that there is a power dynamic that comes with owing someone money.
Be sure you are comfortable being in that position before taking the loan. Above all (as with most family interactions) clear communication of expectations is critical to making the arrangement work out.
2) If both parties are comfortable with an intra-family loan arrangement, the next step is to properly structure the deal. The IRS limits the amount of money you can transfer to an individual in any one year as a gift to $14,000. If you go above that, a gift tax return is necessary to document the gift and the transfer counts against your lifetime exemption level for estate tax purposes. The IRS will likely view a transfer between two parties as a gift unless there are facts to show it was something else.
In order for the transfer to be considered a loan, there are some key elements that must exist. First, a minimum level of interest must be charged. The IRS publishes the minimum rates, called the Applicable Federal Rates (AFR) each month.
Currently, these rates are very low. The rate you use depends on the length of the loan, but the July 2013 AFR rates range from 0.23% - 2.80%. These rates are much lower than what most banks would offer for a home mortgage or auto loan. The IRS also wants to see activity that is usual and customary to a loan, such as regular payments of interest and/or principal, and ideally, a loan note outlining the terms.
3) I strongly suggest documenting the loan in writing with a loan note. This adds a formal feel, and eliminates any question as to whether this was a loan or a gift (for both the borrower and the IRS). If the transfer is ever questioned by the IRS, having the loan properly documented will help support your case.
4) A final consideration is the tax impact to both parties. Generally, interest received on a loan is taxable income to the lender. With intra-family loans, there are a couple of exceptions that can possibly make the arrangement even more favorable. First, if the loan is less than $10,000, the lender is not required to declare the interest as income. (This exemption does not apply if the borrower used the funds to purchase income-producing assets.) If the loan amount is $10,000 - $100,000, the lender must declare the interest as income only if the borrower’s annual investment income (interest, dividends, capital gains, etc.) exceeds $1,000.
If the borrower has investment income exceeding $1,000, then the interest paid to the lender is considered taxable income,but only to the level of the borrower’s investment income. (See Internal Revenue Code Section 7872(d) for more information.)
These exceptions can make the arrangement even more favorable for the lender. They may be able to earn a higher interest rate on the loaned out funds, and not have to pay taxes on the interest.
If the loan is used to purchase a home, the interest paid may still be tax deductible to the borrower. (IRS Publication 936 spells out the details.) In order for this to occur, the loan must be properly recorded as a lien against the property with county government. If this sounds like too much work, there is a service out there that can help.
Check out National Family Mortgage. For a current one-time fee of $725, they will help you properly document the loan and register it with the proper government agency. This is very reasonable when compared to other options. If you want ongoing loan servicing, including monthly statements, funds transfer, and tax form preparation, they do that too for an additional $15 per month.
Intra-family loans can be a great tool for families to help with favorable lending terms, earn higher interest rates on cash, and keep these funds inside the family.
Taking the proper steps to ensure that the loans are set up properly will ensure IRS compliance and increase the likelihood that the arrangement works out for everyone.
The Money Matters column is written by members of the Financial Planning Association of Greater Kansas City. This week: Lucas Bucl (firstname.lastname@example.org), a Certified Financial Planner with KHC Wealth Management, Overland Park.