Cousin Freddy needs a quick loan, and you graciously say, “How much?” and later, you wonder, what have I gotten myself into.
Here’s what you should know before you loan money to friends and family to make sure you avoid any potential tax traps.
Loaning money can be tricky. Not only because of the stress it could put on your interpersonal relationships, but because there could be tax ramifications. If you must lend money to someone close to you, here are some IRS tips for doing it correctly.
- It is necessary to charge interest, even to friends and family. If you don’t charge a minimum rate, the IRS will imply interest in the loan and tax you for the interest income they assume you should be getting. Even if you’re not getting a dime
Charge the correct interest.
- The amount of interest you charge must be reasonable in the eyes of the Internal Revenue Service. The IRS will imply interest at their minimum applicable federal rates (AFRs) if it’s not. Therefore, always charge the interest rate at or above these AFRs, available on the IRS website. The good news is these interest rates are low and almost always below the prime interest rate.
Exceptions, you need to know them.
- If you don’t want to charge interest, you don’t have to IF:
• The money is a gift. In 2021, you and your spouse can each give up to $15,000 to an individual each year.
• The loan is less than $10,000 and is not used to purchase an income-producing property.
- Special tax rules apply if you don’t charge interest, and the loan is used to purchase income-producing property such as capital equipment or to acquire a business. In this case, it’s good to ask your tax pro for assistance.
Get it in writing
- If you expect repayment, write out the terms of your loan. There are a variety of basic loan document formats online that you can use. Creating a loan document may seem unnecessarily formal when dealing with a friend or family member, but it’s essential for two reasons:
1. Document your tax code compliance. By documenting the terms and charging a stated interest rate, you can clearly show you are within tax code rules.
2. Avoid misunderstandings. Creating a written document will clarify that it is a genuine loan, not an informal gift. Your friend or relative will know that you expect the loan to be repaid and when you expect repayment.
If you loan friends or family money, don’t put yourself in a #taxjam; make sure you have followed the rules. If you haven’t done so when you come in for a tax strategy session, we can help you work out the details. Contact us.