Dispel 'Phantom Income' on Family Loans
Suppose your adult child needs a helping hand to launch a new business or buy a home.
Strategy: Give the child a low- or no-interest loan. As long as you stay within the tax law boundaries, your family will have no tax worries. However, if you're not careful, you could be blindsided by an unexpected tax bill.
With the interest rates remaining on the low side, this may be a good time to arrange a loan from a gift-tax perspective.
Here's the whole story: The tax law discourages intrafamily loans where you don't charge any interest or you charge interest at a below-market rate. In brief, interest income may be imputed to the lender under the following sequence:
• You're treated as having charged interest to the borrower. • You're treated as having made a gift of the interest to the borrower.
• The borrower is treated as having used the gift to pay the interest to you.
• You must report the deemed interest income on your tax return.
In other words, you're hit with a tax bill on interest income, even though you never actually receive one thin dime in interest. Tax practitioners often call this "phantom income."
Fortunately, there are two possible ways you may be to able avoid this harsh tax result.
1. Lend less than $10,000. There's a "de minimis exception" in the law for loans totaling $10,000 or less as long as the loan is not directly attributable to the purchase or carrying of income-producing assets.
2. Lend less than $100,000. For loans totaling $100,000 or less, the amount of interest you're treated as receiving annually for tax purposes is limited to the borrower's net investment income for the year. If the borrower's net investment income doesn't exceed $1,000, there's no taxable interest income on the intrafamily loan.
Note that this special exception does not apply if you are using a below-market level interest rate for tax avoidance purposes.
The IRS can be especially tough on loans reputedly made for business purposes. If you can't present clear and convincing evidence that the loan is tied to a business transaction, it may be deemed a gift. Thus, you're not entitled to any tax benefits if the loan isn't repaid.
Sometimes discretion is the better part of valor. Instead of giving your child a no-interest loan, you might charge the child interest based on the Applicable Federal Rate (AFR) for the month of the loan. In recent years, the AFR rates have been very low by historical standards. For example, the monthly rates for loans made in December 2017 are shown below (see box).
Also, spell out in writing the key elements of the loan agreement, including the amount, the time for repayment and the designation of collateral. Finally, have the loan document witnessed and notarized. This way, you'll have proof on your side if the IRS ever challenges the transaction.
If your child can't repay a personal loan, the subsequent loss is treated as a short-term capital loss when it becomes totally worthless (i.e., there's no reasonable prospect for repayment). Therefore, you can use this loss to offset capital gains realized during the year, plus up to $3,000 of ordinary income.
Tip: For a loan made in connection with your business, the full amount of the loss may offset highly taxed ordinary income (e.g., salary).