Interest rates on residential mortgage loans have increased significantly over the last few years. If your adult child or another family member needs a mortgage to buy a home, the interest expense may be unaffordable. Plus, skyrocketing home values and low inventories of for-sale properties in most parts of the country are presenting challenges to prospective home buyers.
You might be considering helping a loved one by making a low-interest-rate family loan. Before offering your assistance, it's important to understand the tax implications and set up your loan so that it will pass IRS scrutiny. Here are some tips to use this strategy in a tax-smart manner.
Get It in Writing
Regardless of the interest rate you intend to charge your family member, you need to be able to prove that you intended for the transaction to be a loan rather than an outright gift. That way, if the loan goes bad, you have the option of claiming a nonbusiness bad debt deduction on your federal income tax return for the year the loan becomes worthless.
The Internal Revenue Code classifies losses from uncollectible personal loans as short-term capital losses. You can use the loss first to offset short-term capital gains that would otherwise be taxed at high rates. Any remaining net short-term capital loss will offset any net long-term capital gain. After that, any remaining net capital loss can offset up to $3,000 of high-taxed ordinary income ($1,500 if you use married-filing-separately status). The remaining net capital loss can be carried forward to the following tax year—or later years, if necessary.
Without a written document, an intended loan to a family member will probably be characterized as a gift by the IRS if you get audited. Then if the loan goes bad, you won't be able to claim a nonbusiness bad debt deduction.
Ill-advised gifts don't result in deductible losses. To avoid this pitfall, your loan should be evidenced by a written promissory note that includes the following details:
You should also document why it seemed reasonable to believe you'd be repaid at the time you made the loan. That way, if the loan goes bad, you have evidence that the transaction was always intended to be a loan, rather than an outright gift.
Set the Interest Rate
Many loans to family members are so-called "below-market" loans. Below-market means a loan that charges no interest or that charges a rate below the applicable federal rate (AFR). AFRs are the minimum rates that you can charge without creating any unwanted tax side effects for yourself. AFRs are set by the IRS, and they usually change every month.
AFRs are generally well below the interest rates that commercial mortgage lenders charge. So, making a loan that charges at least the current AFR makes good sense. This provides your family member a manageable interest rate without causing any tax complications for you.
For a term loan (meaning one with a specified final repayment date), the relevant AFR is the rate in effect for the month you make the loan. For term loans made in April 2024, the AFRs are as follows, assuming monthly compounding of interest:
These rates are significantly lower than the current rates charged by commercial lenders for 15- or 30-year mortgages. If you charge at least the AFR on a loan to a family member, you don't have to worry about any unusual federal tax complications.
Important: For a term loan, the same AFR continues to apply over the life of the loan, regardless of how interest rates may fluctuate in the future. However, if mortgage rates go down, your loved one can potentially refinance with a commercial mortgage lender and pay off your loan.
Different rules apply to demand loans (those that must be repaid whenever you choose to ask for your money back). The annual AFR for a demand loan is a blended rate that reflects monthly changes in the short-term AFRs for that year. So, the annual blended rate can change dramatically if general interest rates change significantly. That creates uncertainty that both you and your family-member borrower probably would prefer to avoid.
The federal income tax results are straightforward if your loan charges an interest rate that equals or exceeds the AFR. You must report the interest income on your federal income tax return. You may also owe state income tax. If the loan is used to buy a home, your family-member borrower can potentially treat the interest as deductible qualified residence interest. To qualify, you must take the legal step of securing the loan with the home. However, your loved one can deduct qualified residence interest only if he or she itemizes.
What Happens If the Interest Rate You Charge Is Below the AFR?
If you charge an interest rate below the AFR on a loan to a family member, the IRS will treat the below-market loan arrangement as an imputed gift to the borrower. The gift equals the difference between the AFR interest you "should have charged" and the interest you actually charged, if any. The borrower is then deemed to pay these phantom dollars back to you as imputed interest income. You must report imputed interest income on your federal income tax return. You may also owe state income tax on imputed interest income, if applicable.
Important: A tax-law loophole is available if all outstanding loans between you and the borrower (with below-market interest or otherwise) add up to $100,000 or less. This loophole involves imputed gifts and imputed interest income with somewhat more favorable tax results. If the loophole is relevant to your situation, your SSB tax advisor can explain how it works. The important thing to know is that a below-market loan that falls under the loophole probably won't cause excessive tax headaches to you or your family-member borrower.
Alternatives to Family Loans
Making a family loan isn't the only way to help a family member buy a home. For instance, if you're feeling quite generous, you could simply make a cash gift to accomplish the goal. Cash gifts up to a certain amount have no federal income tax consequences for either you or your family member.
For 2024, you can make a gift of up to $18,000 to a family member (or anyone else) with no federal tax consequences. If your family member is married, you can make a gift of up to $36,000 (double $18,000) to the family member and his or her spouse with no federal gift tax consequences. And if you're married, you and your spouse can together make a joint gift of up to $36,000 to each family member with no federal gift tax consequences. That means if you're married and your family member is married, you and your spouse can together make a joint gift of up to $72,000 (four times $18,000) to the family member and his or her spouse with no federal gift tax consequences.
If you make a bigger gift, the excess will reduce your unified federal gift and estate tax exemption, assuming you've not made any big gifts in the past. For 2024, the lifetime exemption is $13.61 million (effectively $27.22 million for married couples). You will also have to file a gift tax return.
Other Options
Alternatively, your family member could take out a mortgage from a commercial lender, and you could help make the payments with cash gifts to the family member. These gifts would be subject to the same federal gift tax consequences explained above without any federal income tax consequences for either you or your family member.
Here's another alternative to consider: You could buy the home and give it to the family member. For example, suppose you and your spouse made a joint gift of a home worth $500,000 (net of any mortgage) in 2024 to your family member and his or her spouse. The joint gift would reduce your combined lifetime exemption by $428,000 ($500,000 minus $72,000).
Or you could buy a home, rent it to your family member and eventually leave it to the family member, through your will or living trust document, after you pass away. This option would have federal income tax implications (and state income tax consequences, if applicable).
For More Information
Your SSB tax advisor may have other suggestions. Discuss the tax implications before providing a loved one with assistance when buying a home.
Bottom Line
AFRs usually change monthly, so they're a moving target. If you make a family loan that has written terms and charges an interest rate of at least the AFR, the tax implications for you and the borrower are straightforward. If you charge a lower rate, the tax implications are more complicated.
There are also alternatives to making a loan that you can consider (see "Alternatives to Family Loans," above). Always check with your SSB tax advisor before helping a loved one with their home purchase to get the best tax results.
© 2024