The modern low-interest rate regime fully backs loaning of money to family members. The IRS “below-market” loan rules come into play where it is considered that loans advanced to family members did not get adequate interest rates.
It’s however, possible to loan out family members in a smart way. Here is how to do it:-
Attach an interest rate
The IRS considers it illegal giving out loans with no interest rates to family members. However, charging an interest rate at least equal to the applicable federal rate excludes you from any such complications.
The applicable federal rates on loans whose repayments are certain are as below;
- 14% on short term loans with repayment terms of up to 3 years
- 45% on mid-term loans with repayments periods exceeding three years but are less than nine years
- 17% on long term loans with repayment periods exceeding nine years.
Having it down on paper
Putting the loan in writing enables you prove whether the transaction you entered is a gift or a loan. This enables you claim it as non-business deduction for bad debts when the loan becomes worthless.
IRS accepts personal loans unrecoverable as losses (short term capital losses). The losses are first used to clear short-term capital profits and the rest is used to clear out long term capital profits.
Absence of a written note indicating the principal amount, interest amounts, payment dates, and securities would automatically qualify the loan as a gift.
With such uncertain times, the borrowers might default on loan repayments. As a lender, it might still feel okay to forgive the loan as it’s your loved one. So, then it might feel necessary to treat the loan as a gift.
IRS allows for exemption of gifts, which therefore gives you no burden. However, when the loan is too big, which in most cases is inadvisable to give, it might attract attention. It is okay to turn the loan into a gift as soon as possible.