An interest-free loan or gift to help a family member or friend could have federal income tax consequences, depending on the amount. As explained by George Sanz, CPA, in an article on Bankrate, even though you don’t charge interest on a loan, if the amount is over $10,000 the IRS may require you to impute interest. You would then have to report the interest on your income tax return, even if you don’t collect it.
The interest rate imputed on the loan would be the applicable federal rate (AFR) which is tied to the Treasury bill rates. The IRS publishes these rates underIndex of Applicable Federal Rates (AFR) Rulings on its website. Roy Lewis, in an article in The Motley Fool, also points out that if you lend money to a family member or friend and charge interest at a rate that is below the market rate, you could also have to report interest income at the imputed AFR rate. But the rules for loans at below-market interest rates do not apply for loans of $10,000 or less. They also do not apply to loans for which the proceeds are not directly used to buy stocks or bonds, or other income-producing property. So a loan of less than $10,000 to help out a family member or friend during times of economic difficulties would generally not incur any tax consequences.
If the loan is for more than $10,000 but not more than $100,000, the IRS could impute interest on either a tax-free or below-market interest loan. If the borrower has more than $1,000 in net investment income, which includes interest, dividends and short-term capital gains, you would have to report interest income in an amount equal to the borrower’s net investment income, even if that amount is more or less than the imputed interest that would apply.
For example, suppose you make a $50,000 loan to a family member, who uses the loan to make investments and earns $2,000. If the AFR is 3%, the imputed interest on the loan would be $1,500. You would have to report interest income of $2,000, which is the investment income earned by the borrower. On the other hand, if the borrower earned $1,000 on investments, you would report interest income of $1,000, and not the imputed interest of $1,500.
You could also be liable for federal gift tax if you either make a gift to a family member or friend, or if you forgive interest on a loan. There is an exclusion of $13,000 for each gift to each done. So if your gift is for less than $13,000 you would not owe any gift tax. If you are married both you and your spouse can each give up to $13,000 per year, for a total of $26,000. The same exclusion applies to interest you forgive on a loan. In an article on Entrepreneur it is recommended that you document a loan to avoid an assumption by the IRS that there was no intent to repay the loan, making it a gift subject to gift tax if the amount is over $13,000.
Index of Applicable Federal Rates (AFR) Rulings – IRS
Frequently Asked Questions on Gift Taxes – IRS
George Sanz, CPA, “Tax implications of a family loan” ‘” Bankrate.com
How to Keep Family and Friends Loans Strictly Business – Entrepreneur
Roy Lewis, “Loans to Friends and Family” ‘” The Motley Fool
Rules Regarding No-Interest Family Loans ‘” fivecentnickel.com