Centara Connection

Considerations to Make When Loaning Money to a Family Member

Ryan Coulson, Estate Planning Attorney

Clients often want to help their children or family members by loaning a sum of money for things like the purchase of a home or educational expenses. Clients may know that the IRS generally assumes transfers of money between family members to be a "gift" and must therefore make a loan to preserve their $1,000,000 gift tax exclusion. However, they do not always understand the tax consequences that may be associated with the loan’s structure.

The most common mistake associated with intra-family loans occurs when the client/lender fails to charge an adequate rate of interest, if any. Often, a family member may only request that the principal be repaid by the borrower and fail to charge interest or memorialize the agreement in writing.

Section 7820 of the Internal Revenue Code governs loans that fail to provide “sufficiently” stated interest. If the interest charged is less than the Applicable Federal Rate (AFR), or the government-sanctioned bargain rate, Section 7520 will impute a higher rate for both income and estate tax purposes. The Internal Revenue Code will impute the “foregone interest” as both a gift from the lender to the borrower, as well as income to the lender.

Additionally, despite the fact that the Tax Court has consistently held that the interest due may be “forgiven” to the extent it falls below the annual applicable gift tax exclusion ($12,000 for 2008), the IRS has ruled such transactions to be disguised gifts and has imputed taxes accordingly. In order to prevent this type of treatment, loan records should be drawn up with careful consideration.

In order to prevent these adverse tax consequences we highly recommend that clients consult an attorney before making an intra-family loan. An attorney can help you to satisfy the IRS’ “bona-fide loan” requirement by evidencing the debt with a written agreement, structuring an adequate repayment schedule, and organizing any “forgiveness” of interest to satisfy the IRS requirements.

Centara Legal Group, APC
8880 Rio San Diego Drive, Suite 450
San Diego, CA 92108
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