Understanding Tax treatment of family loans and the gift tax
What you need to know…
Monetary gifts to friends and family members can be up to $17,000 per year (2023) without any issues on Gift Taxes. There are two ways to handle gifts over the “free” limit. One is that you file a gift tax return and the other method is to loan the money to your family in a proper manner. Any amount over the $17,000 per year must be handled by documenting the amount as a loan to avoid Filing IRS Gift Tax Returns. With such generous exemption amounts, the need for loans between family members. Isn’t as prevalent as even a few years ago, with many opting to gift money instead of offering up a loan.
From a tax perspective, it is important to consider the gift tax implications when loaning or gifting money to family members. As of 2024, individuals can gift up to $18,000, without chipping away at any of their lifetime exemption. If you make a gift over the limit, you’ll need to file a gift tax return. However you likely still won’t owe any actual tax due to the generous lifetime gift tax exemption. Given the tax implications of gifts, a loan may be a better option. Since it doesn’t trigger any kind of gift tax exemption amount and, as a result, can be provided in larger amounts because there is no annual exclusion limit.
“Family Gift Loans.”
It is important for you to properly document the loan in writing.
What’s the most common problem that individuals make? It is that they do not document the Family Loans and the Gift Taxes. Especially if they are not planning to ask interest on it. The truth is that even if you are were not going to ask for an interest rate the government requires that you do. Otherwise they impute a nominal rate for you. So, you have to document it in your loan docs for the IRS. If you are going to ask for an interest, you have to document terms of payment and the collateral involved in the loan just to have everything in black and white.
Loan Agreements
Furthermore, if your loan amount exceeds $10,000, the IRS requires a written loan agreement outlining the terms of the loan and repayment schedule, as well as a minimum interest rate called an applicable federal rate (AFR). If you are borrowing or lending less than $10,000 between family members. You don’t have to worry as much about potential tax consequences. Setting up a family loan agreement can help you track all of these decisions in a handy document that can be used for reference when needed.
Likewise, if you will not do this properly you may find yourself paying gift Taxes on the personal loan. The good thing about documenting these loans is that you do not have to use a lawyer for it unless the loan is for a mortgage. You just need to properly document (write) it on your own, this document is called a “note”. Additionally, the borrower can simply shop around for the best rate from traditional lenders. It is important to discuss this option with your financial advisor, accountant, and attorney to avoid errors and tax problems down the road.
Family Loans: The Note
Once you have the note, it is important for you to keep a clear and regular paper trail of it. Especially if the money loaned from you is going to be for mortgage or purchasing a property. Most of the time these loans that are used for mortgages will usually undergo legalization through a title company or a lawyer. The reason why it is important for the loan to be acknowledged in writing is to get the benefit for Income Taxes on mortgage interest.
Additionally, it is crucial to include the term of the loan in the written agreement. Specifying the duration for which the borrower is expected to repay the borrowed funds. This ensures clarity and helps customize the loan based on the borrower’s needs. Separate legal counsel can also be beneficial in this process, as it provides two teams of people who can review the loan and ensure it hits your estate planning objectives.
Having a Note is important
This note will also make it very clear to you, the borrower and the IRS that the money obtained from you is a loan and not as a gift. So this is a clear way of establishing financial obligation to the borrower.
Most of the time, people who are loaning money to their relatives would usually not ask for interest payments. However, if you don’t provide an interest amount in the note the IRS may force you to use their nominal rate. This is what you call imputed interest. The definition of a loan is that it should have an interest rate, and that interest is taxable by the IRS.
Yes Taxes are always involved, and one important aspect to consider is the amount of interest payments. That should be earned on a loan exceeding $10,000. So if you are lending money to a family member but don’t know the financial implications. You may find yourself on the hook to pay taxes on the amount of interest payments. You should have earned on a five-figure loan even if you don’t charge your borrower any interest. It is advisable to charge interest payments if the loan exceeds $10,000. As this will ensure compliance with the applicable federal interest rate (AFR) and avoid any unwelcome tax surprises. The interest income earned from the loan is considered taxable income and must be reported when filing taxes.
Using a Demand Loan to your benefit
Within the note the time period of the loan is required. Using a Demand Loan means that you can demand for the amount to be paid in full whenever you want. But you can just use this for formality with the IRS in terms of computing the imputed gift. Both you and your borrower can still arrange the payment schedule and options informally.
Imputed gift Taxes will be determined on an annual basis on the demand loan within a year. The interest needed to be paid in a year will be given a total amount of $18,000 aside for those larger loans. With this management, you can maximize the amount of total free gifts and save on possible Taxes. Just imagine all the things that you can do if you use the “demand Loan” properly. If you are going to “gift” money to someone, there is no reason to pay Taxes on it too. Setting up the proper structure is important to limit your Taxes. There are various ways to limit your Taxes. You can use a demand loan and use your lifetime benefits of gift Taxes.
Conclusion
If you Gift (2023) $17,000 or less per year to someone it is a “free” transaction on your income tax Returns. But if you gift more than $17,000 (2023) to any one person in a year. You MUST either File a Gift Return for Taxes OR properly document it as a loan with a proper Note. You would just need to be compliant with the Federal interest rates set. We would recommend that you check with an accountant or a tax lawyer. BEFORE you get yourself into trouble. These rates can be found on the IRS’ web page. Still, if you have any questions, please feel free to ask.
FAQs
What is a family loan gift tax?
A family loan gift tax refers to the tax implications of giving a loan to a family member. If the loan is deemed to be a gift, it may be subject to gift tax rules. It’s important to understand these tax implications and consult with a tax professional for guidance.
How does a family loan gift tax work?
Family loan gift tax works by treating a loan as a gift if it charges little or no interest. The IRS rules require clear proof that the loan is not a gift, and one way to establish. This is by charging and collecting interest based on the applicable federal rates. This interest should be in accordance with the IRS rules for the tax code. By following the IRS rules. Such as the minimum annual rates set by the IRS, individuals can ensure that their family loans are recognized as loans and not gifts, thereby minimizing their tax liability. It is advisable to consult with a tax professional for specific advice on how to comply with the IRS rules regarding family loans and the potential tax implications.
Are there any exemptions to paying a gift tax on a family loan?
Yes, there are exemptions to paying a gift tax on a family loan. The IRS allows for certain loan amounts to be considered tax-free if they meet specific criteria. It’s best to consult with a tax professional to determine if your family loan qualifies for an exemption.
How can you avoid paying a gift tax on a family loan?
To avoid paying gift tax on a family loan, make sure to charge an interest rate that is at least equal to the Applicable Federal Rate (AFR) set by the IRS. This way, the loan is considered a bona fide loan rather than a gift and no gift tax will be owed.
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