IRS Tax Rules for Family Loans

Family loans are a good way of advancing funds to your adult children or close relatives at little risk. The recession and mortgage crunch of 2007 really increased the scrutiny by banks on people borrowing funds. Though the bank rates are low, banks have become extremely conservative and have heightened their underwriting rules. For this reason, it may be hard for your children to get a loan from the bank for their education, car, to start a business, or any other expenses. However, you may be at a better position to qualify for a loan and therefore, take out a loan for your child. The IRS does not have any rules that punish taxpayers who advance their children a loan, as long as the loan is advanced at market interest rates. The IRS will only require the lender to report the interest earned and pay income taxes on the interest payments only. The IRS uses the Applicable Federal Rate (AFR) as the minimum interest rate to apply for family loans with no further tax consequences. Therefore, a parent can advance funds to a child at a level interest rate of the AFR at the time of lending.
Below Market Loan Rules
If a parent chooses to advance a significant amount to a child at zero interest or at a rate lower than the AFR, he or she will still have to pay a tax on the interest differential. In other words, the parent or lender will be charged a tax on the interest that he or she would have earned if the AFR was applied to the loan. Therefore, whether a lender applies the AFR, zero interest rate or a rate below the AFR, they will pay the same taxes since the IRS will consider the taxes that should have been paid if the loan was charged at the AFR rate. To avoid the complexities of adjusting for a below-market loan, it is advisable to just charge the Applicable Federal Rate.
Take Advantage of Prevailing Low Rates
The AFR rates have really come down, especially in 2010 and 2011. The low rates enable a parent, friend, or close relative to advance funds at very low and friendly interest rates without any tax implications. For example, in April 2011, the Applicable Federal Rate for short term loans with a duration of less than three years was 0.55%. The rate for mid term loans (between 3-9 years) was 2.46%, and the rate for long term loans (more than 9 years) was 4.17%. Therefore, if a parent advanced a child a house loan to be repaid in 20 years for example, the child will repay the loan at an interest rate of 4.17% for the whole duration of the loan, irrespective of whether the AFR rises or not.
Demand versus Term Loans
The rule of applying a level AFR for a given loan throughout the duration of the loan only pertains to a term loan. Term loans are loans that are advanced with clear terms set at the start of the loan; the loan is to be repaid at a specified time or in specified installments at set dates. If on the other hand, the loan is a demand loan, then the IRS will require the lender to keep changing the interest rate with changes in the AFR. A demand loan is a loan with no set rules and the lender can demand repayment at anytime. A demand loan therefore, cannot take maximum advantage of prevailing low rates, as the applicable interest for taxation will rise as the AFR rises.
Zero Interest Small Loans
The IRS applies the AFR and the below-market-loan rules on only significant loans that are above $10,000.00. For loans below this threshold, the IRS does not require the lender to charge interest. Therefore, the loan can be distributed interest-free without any tax implications. However, if interest is applied to the loan, the lender will report the actual interest earned as income and pay taxes on it.
 

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