The Tax-Smart Way to Lend to Loved Ones

Helping out a family member by loaning them money is a noble deed. But did you know you can (and should) get a little something out of the deal, as well? Here's how you can lend to loved ones the tax-smart way.

If you make a loan to a family member and charge zero interest, you may face some unfavorable and complicated tax rules (more on this later). To avoid these tax-law complications, you can charge an interest rate that is equal to the IRS-approved applicable federal rate (AFR) or higher. The good news is that AFRs are incredibly low right now. So you can sidestep messy tax rules without having to charge your family member much interest.

Currently, the AFRs for term loans -- which means loans with a defined repayment schedule or a specific balloon payment due date are as follows (based on semiannual compounding):

* 0.72% for “short-term” loans of up to three years.

* 1.93% for “midterm” loans over three years, but not over nine years.

* 3.49% for “long-term” loans over nine years.

AFRs are updated monthly in response to ever-changing bond market conditions. Today’s super-low AFRs reflect the current super-low rate environment, which may not last much longer. AFRs for each month are published in Internal Revenue Bulletins and can be found at IRS.gov. With a term loan, the AFR on the month you make the loan applies for the entire term.

Say you want to lend $50,000 to your adult son so he can buy his first home at a price that seemed inconceivable a year or two ago. You could make a nine-year term loan with a balloon repayment at the end and charge the midterm AFR, which right now is only 1.93%. Your son can then pay that super-low rate for the entire nine years.

Likewise, you can extend the term loan to 15 years and charge interest equal to the long-term AFR, which is only 3.49%, and your son can pay that low rate for the entire 15 years.

On your side of the deal, you must include the interest income on your Form 1040. On your son's side of the deal, he can deduct the interest as qualified residence interest, as long as the loan is secured with his home (a relatively simple legal procedure). Otherwise, your son generally can’t deduct the interest.

One trap to avoid: If you make a demand loan (one where you can demand repayment at any time), as opposed to a term loan, the AFR is not fixed in the month you make the loan. Instead, you must charge a floating AFR based on ever-changing short-term AFRs. So if you believe (as I do) that interest rates will eventually go higher and you want to offer a great interest rate to your borrowing family member, you’ll want to make a term loan.

Insist on making a totally interest-free loan to a family member, and prepare for the possibility that you'll get hit with the dreaded below-market interest rules. If you do, you must follow complicated rules to calculate imaginary interest payments from the borrower to you. Then you have to pay real, live income taxes on the imaginary interest. Those imaginary interest payments can also trigger imaginary gifts from you to the borrower, which may eat into your valuable federal gift and estate tax exemptions. Sound crazy? Yes. But I didn’t make these rules. Your beloved Congress did.

For loans under $100,000, there are some exceptions to the below-market loan rules. But the preferable approach is to avoid them entirely by charging an interest rate equal to the AFR. Plus, I think it’s best to charge some interest on family loans, just to keep the arrangement on a business-like footing -- and help you avoid some unnecessary grief.

Last but not least, put the loan in writing to make sure the IRS (and the borrower, too) will respect the deal as a loan rather than a gift. This is easy to accomplish because several online services offer do-it-yourself loan documents for just a few bucks (for instance, check out www.nolo.com). I also advise collecting loan interest payments at least semiannually and principal payments promptly when due. That shows you’re serious about getting your money back -- with interest (albeit at a very favorable rate). Follow these simple precautions, and you can give your family-member borrower some pretty great loan terms while keeping the IRS off your back.