When we’re in need of money – whether for a business investment or personal use – a common source of funds is our family members and close friends. These are people who know we’re trustworthy and often want to help us out in times of need or when a promising business opportunity presents itself.
However, few people making or receiving these informal loans are aware that there may be tax implications for these transactions. If you’re not careful, what you thought was a gesture of goodwill between friends can turn into a nightmare with the IRS.
Loans Bearing a Market Rate of Interest
When friends and family members loan each other money at a market rate of interest, the loans are subject to the same tax rules governing loans between an individual and an unrelated third party. The person lending the money must report the interest payment as income on his or her yearly tax return. If the person borrowing the money uses the loan proceeds for business purposes, he or she is entitled to a deduction in the amount of the interest paid. No deduction is allowed if the proceeds are used for personal or non-business purposes.
Loans with No Interest or Below-Market Interest
Friends and family members often make loans to each other without charging any interest or charging only a nominal amount, since such loans are generally made as a favor to the borrower and not for the purpose of earning a profit. If you are a party to this type of loan, it’s important for you to know about the applicable tax rules so a generous gesture doesn’t result in a nightmare with the IRS.
In the case of no-interest loans, most people believe there is no taxable income because no interest is paid. The IRS doesn’t view it that simply. In fact, the tax rules are astonishingly complex and counterintuitive when it comes to no-interest loans. Even though no interest is paid to the lender, the IRS will treat the transaction as if the borrower paid interest at the applicable federal rate to the lender and the lender subsequently gifted the interest back to the borrower. This treatment results in two taxable events: income to the lender and a gift to the borrower. The lender is taxed on the imaginary interest income and, depending on the amount, may also be liable for gift tax on the imaginary payment made back to the borrower. As they say, “No good deed goes unpunished”!
In the case of a loan with a rate of interest below the applicable federal rate, the IRS will treat the transaction similar to a loan with no interest; however the amount of “imaginary interest” will equal the difference between interest calculated at the applicable federal rate and the amount of interest actually paid.
Fortunately, many loans between friends and family members are exempt from the harsh “imputed interest” rules explained above. For example, loans for $10,000 or less are exempt as long as the loan proceeds are not used to purchase income-producing assets. For income tax purposes, imputed interest on loans for more than $10,000 but less than $100,000 is limited to the borrower’s net investment income for the year, and no interest is imputed if the borrower’s net investment income is less than $1,000. However, the imputed interest rules will apply for purposes of the gift tax.
Loans to US citizens or residents from individuals residing outside the US are often exempt from the harsh imputed interest rules; however, where interest is actually paid, it is subject to strict reporting requirements. Any interest payments must be reported on IRS Form 1042-S, Foreign Person’s US Source Income Subject to Withholding. Because interest paid to a foreign person is generally exempt from income tax, under most circumstances, no tax on the interest is owed.
On the other hand, loans made to a foreign person from a US citizen or resident are subject to the same imputed interest rules as those applicable to domestic transactions.