Did you know that interest-free loans of money to your friends and family can be considered a taxable gift for federal gift tax purposes? This article will help you understand the circumstances under which such gift treatment might occur.
In 1984, the U.S. Supreme Court determined that the interest-free use of money constitutes a gift for federal gift tax purposes. Thereafter, Congress enacted a tax provision which reaffirms this concept. When a person makes an interest-free term loan to a family member, the foregone interest is treated as an amount transferred from the lender to the borrower as a gift. The value of that gift is the difference between the amount loaned and the value of a loan for the loan period, and is computed using the applicable current interest rate.
For example, an interest-free loan of $100,000 for a three-year period may be treated for tax purposes as a $90,000 loan and a $10,000 immediate taxable gift. In this scenario, the $10,000 is assumed to be the calculated interest on a three-year, $90,000 loan. Of course, the actual interest amount is dependent on the specific features of your loan, including the loan amount, the term and the market interest rate at the time the loan is made. For income tax purposes, this $10,000 calculated interest amount is then treated as transferred by the borrower to the lender as interest paid over the loan period. This second segment of the deemed transaction will generate interest income to the lender. It may produce an interest expense deduction to the borrower, but the deductibility is dependent upon the use of the borrowed funds. For example, if the borrower uses the funds to start a business, the interest may be deducted as a business expense.
If the loan is considered a demand loan, a loan that can be called for complete repayment at any time, the term of the loan is unknown. Therefore, the interest income cannot be calculated over the life of the loan. For demand loans, the gift value is deemed transferred for each tax year during which the repayment demand is not made. The income tax effect is the same as a term loan: the lender will have annual taxable income, and the borrower may have a tax deduction. In either of these scenarios, the gift and income tax impact cannot be avoided by signing an interest-bearing loan and then forgiving the interest annually.
Since the borrower has the current enjoyment of the funds, the imputed interest may be offset on your gift tax return by the annual gift tax exclusion ($15,000 for 2019). If you and your spouse are willing to split gifts, or if the loan was made from joint or community property funds, that exclusion amount is doubled.
The applicable interest rate used for this purpose is called the Applicable Federal Rate (AFR). Interest rate tables are published each month by the Internal Revenue Service. The tables list the minimum interest rate that may be used for personal loans. These rates change monthly and different rates are provided depending on the length of the loan.
There is an exception when interest-free loans between individuals do not constitute a taxable gift. When the amount of the loan does not exceed $10,000 no taxable gift or deemed interest income and expense is created. This exception does not apply, however, when the interest-free loan is for the purchase or carrying of income-producing assets.
Further, for one or more interest-free loans directly between individuals of $100,000 or less, the amount of interest income and expense treated as retransferred by the borrower to the lender at the close of any year may not be exceed the borrower’s net investment income for that year. However, this limitation does not apply where one of the principal purposes of the loan arrangement is the avoidance of federal tax.
Taxes due on interest-free loans are complicated, but the real objective of these tax provisions is to reduce the family loan transaction to its true economic components. The idea is to measure what would have been the results if the parties had dealt with each other on an arm’s-length basis. Ultimately, for federal gift tax purposes, the donor is treated as making a gift of the value of the use of the money. If the loan is a term loan, the entire value of the loan is an immediate gift.
If you have outstanding loans that are subject to these provisions, we may want to discuss filing gift tax returns to report the deemed gift or charging an interest rate to those loans. Please contact us if you require further clarification on the gift tax consequences on interest-free family loans.