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Below-market-rate loans to relatives and
friends involves special tax treatment. Questions often arise concerning
the treatment of loans to relatives and friends at below-market interest rates --
frequently interest-free for convenience.
Interest-free loans to offspring were once used by parents as an income-shifting
strategy. The offspring could invest the funds and pay tax on the income at a lower tax
rate than the parents. After the Supreme Court ruled that this unstated interest was a
taxable gift, however, legislation was enacted in 1984 to clarify the tax treatment of
below-market-rate (BMR) loans. While this effectively curtailed the tax advantages of BMR
loans, some tax planning opportunities still exist.
Types of Loan:
- A demand loan is a loan that is payable in full at any time upon demand
by the lender. It is a BMR loan if the interest rate is less than the Applicable
Federal Rate (AFR) -- the market interest rate established periodically by the IRS.
- A term loan is any loan that is not a demand loan. It is a BMR loan if
the amount loaned exceeds the present value (applying the appropriate AFR) of all payments
due under the loan.
Tax Treatment of BMR Loans (General Rule): For a demand loan, the
foregone interest is treated as being transferred from the lender to the borrower as a
gift and then back to the lender as interest on the last day of the calendar year. For
example, if Mother makes an interest-free demand loan to Son of $100,000 on Jan. 1, the
tax impact at the end of one year may be illustrated as follows:
For a term loan, the borrower is treated as receiving cash (generally as of the date of
the loan) equal to the excess of the amount loaned over the present value of all payments
required under the terms of the loan. The BMR loan will be treated as having original
issue discount (OID) equal to this excess amount.
Example: On Jan. 1, Father makes an interest-free
loan to Daughter of $114,490, due on Dec. 31 of the following year. When the present value
(using an AFR of 7%) of loan payments ($100,000) is deducted from the amount loaned
($114,490), it results in OID of $14,490. Subject to certain exceptions discussed below,
father will have the following reporting requirements in Year 1 and Year 2:
| |
Year 1 |
Year 2 |
Total OID
Recognized |
Present Value
of Loan Payments |
$100,000 |
$100,000 |
|
Plus Prior Year
Imputed Interest |
|
$7,000 |
|
| Total |
$100,000 |
$107,000 |
|
| Interest Income
(multiply total by AFR) |
$7,000 |
$7,490 |
$14,490 |
Father is deemed to have made a gift to Daughter of $14,490 in Year
1, which (because it exceeds the $10,000 individual gift threshold) will require that a
1996 gift tax return be filed (although no gift tax would be due if the gift was made
jointly by Father and Mother).
- Exception 1: De minimis loan of up to $10,000. If the loan is
between individuals, these rules (regarding the income and gift tax effects) do not apply
on any day on which the aggregate outstanding amount of loans between such individuals
does not exceed $10,000. Under this exception, the loan cannot be used to purchase or
carry income-producing assets.
- Exception 2: Non-investment loan of up to $100,000. There is also an
exception to these rules (regarding the income tax effects but not the gift tax effects)
for loans of up to $100,000 between individuals when the borrower’s net investment
income (e.g., taxable interest and dividends) does not exceed $1,000. If the
borrower’s net investment income exceeds $1,000, there will be imputed interest, but
such interest is limited to the borrower’s net investment income.
Example: On Jan. 1, Mary makes interest-free loans
of $100,000 to each of her good friends, Joe, Jill and Jim. the loans are due on Dec. 31,
and the APR is 7%. Mary will report the following imputed interest income and taxable
gifts:
| |
|
Joe |
Jill |
Jim |
| 1. |
Amount loaned |
$100,000 |
$100,000 |
$100,000 |
| 2. |
Less present value
of loan payments at 7% |
($93,458) |
($93,458) |
($93,458) |
| 3. |
Imputed interest
before limitation |
$6,542 |
$6,542 |
$6,542 |
| 4. |
Borrower's
investment income for the year |
$950 |
$4,000 |
$8,000 |
| 5. |
Mary's taxable
imputed interest * |
0 |
$4,000 |
$6,542 |
| 6. |
Mary's taxable gifts
¤ |
$6,542 |
$6,542 |
$6,542 |
Footnotes:
* The lesser of line 3 or line 4; if line 4 is $1,000 or less, line 5 is zero.
¤ Before any $10,000 exclusion from gifts is applied. |
Other Considerations:
- These rules apply to BMR loans where the foregone interest is in the nature of a gift.
Similar rules define the tax consequences of BMR loans between (1) employers and
employees, and (2) corporations and shareholders.
- A husband and wife are treated as one person for purposes of theses rules.
- Whether the borrower will be able to deduct the imputed interest on his or her income
tax return will depend on how the proceeds are applied (e.g., if a certificate of deposit
is purchased, the imputed interest may qualify as investment interest).
These are just some thoughts to consider. Your tax advisor can provide additional
information and should be consulted before any action is taken.
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