Important Considerations Before Loaning Money To A Family Member

Bloomfield Township estate planning lawyer

People typically lend to family members for various reasons. For instance, lending your daughter money so that she can start a new business or lending money to your son so that he can buy his first home. You might find yourself in such a situation at some point. It is thus important to understand how this might affect you from a tax perspective.

If you are planning to charge the borrower interest on the loan, you are required by law to pay income tax on the interest collected. The IRS expects you to charge interest when you lend money just as a bank would in spite of the fact that the recipient is a family member.

Bearing this in mind, the IRS has set an Applicable Federal Rate (AFR) which varies based on the term of the loan as well as the month. If you visit the IRS website, you will find a list of Applicable Federal Rates, by the month. If you fail to charge interest on the loan, the IRS regards it as a “gift loan,” which means that special rules will come into effect.

Loans of less than $10,000 between individuals are typically disregarded. If you do charge interest but less than the AFR for loans between $10,000 and $100,000, the difference will be considered a gift for which you are required to pay a gift tax for should your total annual gift tax exceed 14,000.

If the loan is more than $100,000, the IRS will consider the foregone interest a gift and will also assume automatically that you received the foregone interest as an interest payment, which means that you will be required to pay income tax on the money.

For example, you lend your son $150,000 in a 5-year interest-free loan with a 2.85 percent AFR, the IRS will assume that you have been receiving interest amounting to $4,275 each year. You will subsequently be required to pay income tax on the amount each year. If you are a person with a combined 40 percent state and federal income tax rate, the net effect would be $1,710 in extra taxes each year.

However, it is possible to get around this, like using an Irrevocable Trust. You can set up your Trust such that any transactions between the Trust and yourself are not regarded as income. For this reason, if you lend the Trust $150,000, the IRS would only ignore the foregone interest when it is calculating tax liability. The foregone interest can still be regarded as a gift, but it is possible to design the Trust so that a gift to the Trust is considered to be a gift to a family member. The annual gift tax exclusion has been stuck at $14,000 since 2014.

The Bottom Line

If you are thinking about loaning money to someone, it is important to consult with an experienced and qualified estate planning lawyer to make sure that you structure your loans in such a way that they don’t generate extra taxation of your income.

Schedule Your Free Consultation with Our Michigan Experienced Estate Planning Attorney

Einheuser Legal, P.C. is an estate planning law firm in Bingham Farms, Michigan. We help families set up wills and living trusts. Attorney Michael Einheuser is an experienced estate planning lawyer serving residents in Bingham Farms, Troy, Farmington Hills, Rochester Hills, Southfield, West Bloomfield Township and Bloomfield Township.

Schedule your free consultation today by calling 248-398-4665.

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