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Family Loans

Where can you get the best terms on a new loan? Often, it's the family bank, meaning Mom and Dad, your successful big brother or your great aunt Doris. You can usually get away with a low interest rate, or perhaps no interest at all. Trouble is, loans among family members touch on two areas about which the IRS is especially sensitive: gifts and interest income. To avoid a tax nightmare later, be sure to follow these rules.

Document the Loan
The first step to avoiding trouble is to clearly document that the money is actually a loan, with or without interest. The documentation should also include payment terms and the collateral for the loan, if any. This will avoid conflict about what exactly you agreed to pay. And, if you don't do this, your lender could find himself paying income taxes on interest he never received and gift taxes on money he never gave away. And, in the long term, the loan could cut into the lender's lifetime estate tax exemption.

You don't need a lawyer to draw up the documentation. In fact, you can easily satisfy the IRS with a do-it-yourself document. Try the document-creation software from Parsons Technology called Quicken Family Lawyer, which sells for about $29. It's simple and well worth the price, even if you use it only once.

Secure the Note
If you are borrowing money to buy a new home, you should take the extra step of legally securing the note with your residence. (This does require a lawyer.) That way you can take advantage of one of the most popular tax deductions: interest on a home mortgage. Anyone thinking of not reporting a loan should consider this point. You could face criminal charges if you falsify a mortgage application to hide the origin of the loan money.

Establish Solvency
In order to clarify that the loan is not a gift, the lender should write a memo establishing that you, the borrower was solvent at the time of the loan. This proves the lender has a reasonable expectation of repayment and is not actually making a gift.

Set an Interest Rate
Interest-Free doesn't mean hassle-free. Many loans among family members are interest-free. But be careful. If you don't set an interest rate, the IRS, in its family-friendly way, will do it for you. And since that interest would be considered income for the lender, the IRS will happily tax the interest payments that were never paid. You have now entered the hideously complex world of "imputed interest." Essentially, the IRS, eager to raise revenue, has decided that for a loan to be a loan, interest must be paid, and if interest is being paid, someone is making taxable income.

The IRS's enthusiasm does not stop there. Not only does the agency place a tax on imaginary income, but it assumes that the borrower could not afford to make the interest payments (he had to borrow money, didn't he?) and then acts as though the lender gave him the money to pay the interest. Enter the gift tax. So the money the lender never received but pays taxes on anyway could also count against the $10,000 annual tax-free gift limit, and if it exceeds that, then the lifetime estate tax exemption. This is not all as bad as it sounds, and in most cases these penalties can be avoided with good planning.

Avoid Imputed Interest
First, imputed interest and all the crazy imputed income and gift tax problems generally do not apply when a loan totals no more than $10,000. However, watch out for this: The $10,000 limit applies to all outstanding loans between you and the lender, including those charging interest. But if the $10,000 rule does not help, you can turn to the $100,000 rule.

The $100,000 rule applies when the aggregate balance of all outstanding loans (interest-free or otherwise) between you and the lender is $100,000 or less. For income tax purposes, the amount of imputed interest is zero if the borrower's net investment income for the year is no more than $1,000. (Net investment income, which includes interest, dividends and certain royalties, but not necessarily capital gains, is the figure used to determine how much margin-account interest can be deducted on Schedule A.) Since most people who borrow money from family members are probably not sitting on large investment portfolios, imputed interest can generally be avoided.

Under the $100,000 rule, when the borrower's net investment income exceeds $1,000, imputed interest is limited to the actual amount of investment income. Here is an example: If a mother lends her daughter $100,000 interest-free but the IRS sets an interest rate of 5 percent, then the mother would have to declare imputed interest payments of $5,000. But if the daughter's investment income is less than $1,000, the imputed interest would be zero. If the daughter earned $1,500 in interest income, the mother would have to pay taxes on $1,500 rather than $5,000.

To qualify for the $100,000 rule, the lender must have an annual statement that discloses the borrower's net investment income.

Demand a Demand Loan
Sa far, so good. Unfortunately, the $100,000 rule gets really tricky when it comes to the gift tax. The net investment income rule does not apply here. To minimize gift tax problems, designate the interest-free advance as a "demand loan." This means the lender can demand full repayment at anytime. While this may seem unduly threatening, it could save your lender money because of the way the IRS calculates the imputed gift. You can still informally agree on a repayment schedule. With a demand loan, the amount of the imputed gift is calculated on a yearly basis. Interest payments on all but the biggest loans will total less than $10,000 a year, so the imputed gift for each year the loan is outstanding will fall harmlessly below the $10,000 annual limit for tax-free gifts.

But if you do not designate the loan a demand loan, the IRS will add up all the interest you would pay for the life of the loan and count it as a gift in the year the loan is made. The result could be a relatively large imputed gift that exceeds the $10,000 annual tax-free limit, and also cuts into the lender's lifetime estate tax exemption.

These rules can get tricky, though, so it is probably a good idea to consult a tax pro before drawing up this kind of loan. The IRS will let you avoid all these hassles if you simply charge interest on the loan. The IRS uses what it calls applicable federal rates, which change monthly, to determine if the interest rate is proper. If the lender charges at least the applicable federal rates, he simply reports the interest payments as taxable income. You can find those rates on the IRS web site.

What if You Default
There are few things that hurt family relations more than bad debts. But the IRS is not ashamed to get involved. If your lender tries to write off your bad debt on his tax return, the IRS will then seek to collect the lost tax from you. Think it won't happen? Well, a 1995 U.S. Tax Court case tells the story of a father who made thousands of dollars in undocumented loans to his 23-year-old daughter, who wanted to open a roller-skating rink.

The skating rink eventually failed, and the father claimed a $35,000 nonbusiness bad-debt deduction, even though no formal collection efforts were undertaken against his daughter. (She had filed for bankruptcy four months earlier.) The Tax Court concluded that the advances were loans because of "loan" notations the father had made on some of the checks, and because he had previously made undocumented loans to family members and friends and had been repaid.

So the IRS's collection efforts against the daughter were approved.

(Copyright 2001 SmartMoney.com. All Rights Reserved. This material may not be published, rewritten, or redistributed.)
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