A Good Time for Making Tax-Smart Family Loans

Interest rates on residential mortgage loans have increased significantly over the last few years. If your adult child or another family member needs a mortgage to buy a home, the interest expense may be unaffordable. Plus, skyrocketing home values and low inventories of for-sale properties in most parts of the country are presenting challenges to prospective home buyers.

You might be considering helping a loved one by making a low-interest-rate family loan. Before offering your assistance, it's important to understand the tax implications and set up your loan so that it will pass IRS scrutiny. Here are some tips to use this strategy in a tax-smart manner.

Get It in Writing

Regardless of the interest rate you intend to charge your family member, you need to be able to prove that you intended for the transaction to be a loan rather than an outright gift. That way, if the loan goes bad, you have the option of claiming a nonbusiness bad debt deduction on your federal income tax return for the year the loan becomes worthless.

The Internal Revenue Code classifies losses from uncollectible personal loans as short-term capital losses. You can use the loss first to offset short-term capital gains that would otherwise be taxed at high rates. Any remaining net short-term capital loss will offset any net long-term capital gain. After that, any remaining net capital loss can offset up to $3,000 of high-taxed ordinary income ($1,500 if you use married-filing-separately status). The remaining net capital loss can be carried forward to the following tax year — or later years, if necessary.

Without a written document, an intended loan to a family member will probably be characterized as a gift by the IRS if you get audited. Then if the loan goes bad, you won't be able to claim a nonbusiness bad debt deduction.

Ill-advised gifts don't result in deductible losses. To avoid this pitfall, your loan should be evidenced by a written promissory note that includes the following details:

You should also document why it seemed reasonable to believe you'd be repaid at the time you made the loan. That way, if the loan goes bad, you have evidence that the transaction was always intended to be a loan, rather than an outright gift.

Set the Interest Rate

Many loans to family members are so-called "below-market" loans. Below-market means a loan that charges no interest or that charges a rate below the applicable federal rate (AFR). AFRs are the minimum rates that you can charge without creating any unwanted tax side effects for yourself. AFRs are set by the IRS, and they usually change every month.

AFRs are generally well below the interest rates that commercial mortgage lenders charge. So, making a loan that charges at least the current AFR makes good sense. This provides your family member a manageable interest rate without causing any tax complications for you.  

For a term loan (meaning one with a specified final repayment date), the relevant AFR is the rate in effect for the month you make the loan. For term loans made in April 2024, the AFRs are as follows, assuming monthly compounding of interest:

These rates are significantly lower than the current rates charged by commercial lenders for 15- or 30-year mortgages. If you charge at least the AFR on a loan to a family member, you don't have to worry about any unusual federal tax complications.

Important: For a term loan, the same AFR continues to apply over the life of the loan, regardless of how interest rates may fluctuate in the future. However, if mortgage rates go down, your loved one can potentially refinance with a commercial mortgage lender and pay off your loan.      

Different rules apply to demand loans (those that must be repaid whenever you choose to ask for your money back). The annual AFR for a demand loan is a blended rate that reflects monthly changes in the short-term AFRs for that year. So, the annual blended rate can change dramatically if general interest rates change significantly. That creates uncertainty that both you and your family-member borrower probably would prefer to avoid.

The federal income tax results are straightforward if your loan charges an interest rate that equals or exceeds the AFR. You must report the interest income on your federal income tax return. You may also owe state income tax. If the loan is used to buy a home, your family-member borrower can potentially treat the interest as deductible qualified residence interest. To qualify, you must take the legal step of securing the loan with the home. However, your loved one can deduct qualified residence interest only if he or she itemizes.

What's an Appropriate Interest Rate to Charge?

Most loans to family members are so-called "below-market" loans in tax terminology. Below-market means a loan that charges no interest or a rate below the applicable federal rate.

AFRs are the minimum interest rates you can charge without creating unwanted tax side effects for yourself. These rates are set by the IRS, and they can potentially change every month.

You might be surprised by how low AFRs are right now. Making an inter family loan that charges the AFR, instead of 0%, makes sense if you want to give your relative a low interest rate without causing any unwanted tax complications for yourself.  

For a term loan (one with a specified final repayment date), the relevant AFR is the rate in effect for loans of that duration for the month you make the loan. Here are the AFRs for term loans made in June and July.

AFRs for Term Loans

The same AFR continues to apply over the life of a term loan, regardless of how interest rates may fluctuate. Currently, AFRs are significantly lower than the rates charged by commercial lenders. If you charge at least the AFR on a loan to a family member, you don't have to worry about any unexpected federal tax complications.

If you make a demand loan that you can call due at any time, instead of a term loan, the AFR for each year will be a blended rate that reflects monthly changes in short-term AFRs. That means the annual blended rate for a demand loan can change dramatically depending on general interest rate fluctuations. In contrast, making a term loan that charges the current AFR avoids any interest-rate uncertainty, because the same AFR applies for the entire life of the loan.

The federal income tax results are straightforward if your loan charges an interest rate that equals or exceeds the AFR: You must report the interest as income on your tax return. The borrower (your relative) may or may not be able to deduct the interest, depending on how the loan proceeds are used.

Important: If the loan proceeds are used to buy a home, the borrower can potentially treat the interest as deductible qualified residence interest if you secure the loan with the home. However, qualified residence interest won't cut the borrower's federal income tax bill unless he or she itemizes.  

What Happens if You Charge an Interest Rate Below the AFR?

The tax results can get complicated if your loan charges interest at a rate that's lower than the AFR. The interest on a below-market family loan rate is treated as an imputed gift to the borrower for federal tax purposes. The value of the imputed gift equals the difference between the AFR interest you should have charged and the interest rate you actually charged (if any).

The borrower is then deemed to pay this amount back to you as imputed interest income. Though no cash is exchanged for imputed interest, imputed interest income must be reported on your federal income tax return. But with today's low AFRs, the imputed interest income and the related tax hit will be negligible or nearly negligible — unless you make a large loan.

Some family loans may be eligible for the following two taxpayer friendly, imputed-interest loopholes:

1. The $10,000 Loophole. For below-market loans of $10,000 or less, the IRS lets you ignore the imputed gift and imputed interest income rules. To qualify for this loophole, all outstanding loans between you and the borrower must aggregate to $10,000 or less. In that case, you can charge an interest rate below the AFR, and there won't be any federal tax consequences — even if you charge no interest.    

Important: You can't take advantage of the $10,000 loophole if the borrower uses the loan proceeds to buy or carry income-producing assets.  

2. The $100,000 Loophole. With a larger below-market loan, the $100,000 loophole can save you from unwanted tax results. To qualify for this loophole, all outstanding loans between you and the borrower must aggregate to $100,000 or less.

Under this loophole, if the borrower's net investment income for the year is no more than $1,000, your taxable imputed interest income is zero. If the borrower's net investment income exceeds $1,000, your taxable imputed interest income for the year is limited to the lower of:

With today's low AFRs, the imputed interest income amount and the related federal income tax hit will be negligible (or close to negligible) even on a $100,000 loan that charges 0% interest.

The federal gift tax consequences under the $100,000 loophole are tricky. But with today's low AFRs and generous unified federal gift and estate tax exemption, these rules probably won't matter much (if at all) for a below-market loan of up to $100,000.

The amount of the imputed gift won't be very large, and the unified federal gift and estate tax exemption for 2020 is $11.58 million, or effectively $23.16 million for a married couple. This generous exemption translates into a small chance of any meaningful gift tax consequences from making a below-market loan of up to $100,000, even if you charge 0% interest.    

Need Help?

Your tax advisor can help make imputed interest calculations on below-market loans to determine what's right for your situation. However, below-market loans made right now — while AFRs are low and the unified federal gift and estate tax exemption is generous — probably won't make any meaningful difference to your tax situation. That said, AFRs usually change every month, so the tax results from making a below-market loan can be a moving target.

Bottom Line

AFRs usually change monthly, so they're a moving target. If you make an inter family loan that has written terms and charges an interest rate of at least the AFR, the tax implications for you and the borrower are straightforward. If you charge a lower rate, the tax implications are more complicated.

There are also alternatives to making a loan that you can consider (see "Alternatives to Family Loans," below). Always check with your tax advisor before helping a loved one with their home purchase to get the best tax results.

Get Your Loan in Writing

Regardless of the interest rate you intend to charge (if any) on a loan to a family member, you want to be able to prove that you intended the transaction to be a loan, rather than an outright gift. That way, if the loan goes bad, you can claim a non-business bad debt deduction on your personal federal income tax return for the year the loan becomes worthless.

Losses from non-business bad debts are classified as short-term capital losses. Capital losses are valuable because they can offset capital gains and potentially up to $3,000 of income from other sources, or up to $1,500 if you use married filing separate status.

Without a written document, if you get audited, the IRS will probably characterize your intended loan as a gift. Then, if the loan goes bad, you won't be able to claim a non-business bad debt loss deduction. In fact, you won't be able to deduct anything, because ill-advised gifts don't result in deductible losses. To avoid this problem, document your loan with a written promissory note that includes the following details:

Also document why it seemed reasonable to think you'd be repaid at the time you made the loan. That way, if the loan goes bad, you have evidence that you always intended for the transaction to be a loan. Your tax advisor can help you put together appropriate documentation.

Alternatives to Family Loans

Making an inter family loan isn't the only way to help a family member buy a home. For instance, if you're feeling quite generous, you could simply make a cash gift to accomplish the goal. Cash gifts up to a certain amount have no federal income tax consequences for either you or your family member.

For 2024, you can make a gift of up to $18,000 to a family member (or anyone else) with no federal tax consequences. If your family member is married, you can make a gift of up to $36,000 (double $18,000) to the family member and his or her spouse with no federal gift tax consequences. And if you're married, you and your spouse can together make a joint gift of up to $36,000 to each family member with no federal gift tax consequences. That means if you're married and your family member is married, you and your spouse can together make a joint gift of up to $72,000 (four times $18,000) to the family member and his or her spouse with no federal gift tax consequences.

If you make a bigger gift, the excess will reduce your unified federal gift and estate tax exemption, assuming you've not made any big gifts in the past. For 2024, the lifetime exemption is $13.61 million (effectively $27.22 million for married couples). You will also have to file a gift tax return.

Other Options

Alternatively, your family member could take out a mortgage from a commercial lender, and you could help make the payments with cash gifts to the family member. These gifts would be subject to the same federal gift tax consequences explained above without any federal income tax consequences for either you or your family member.

Here's another alternative to consider: You could buy the home and give it to the family member. For example, suppose you and your spouse made a joint gift of a home worth $500,000 (net of any mortgage) in 2024 to your family member and his or her spouse. The joint gift would reduce your combined lifetime exemption by $428,000 ($500,000 minus $72,000).

Or you could buy a home, rent it to your family member and eventually leave it to the family member, through your will or living trust document, after you pass away. This option would have federal income tax implications (and state income tax consequences, if applicable).

For More Information

Your tax advisor may have other suggestions. Discuss the tax implications before providing a loved one with assistance when buying a home.

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