Your oldest son has just informed you that he and his wife want to buy their first home, but they can’t afford the down payment. Even with favorable interest rates available for some, bank loans are still hard to come by, especially for younger borrowers. As a result, many young families turn to their parents or other relatives for intra-family loans. Once you understand the tax consequences of intra-family loans, an intra-family loan can not only benefit the recipient, but also serve as a good estate planning tool.
Treatment of the loan as a gift
There is a chance that the IRS will treat the loan as a gift, regardless of the fact that a promissory note was actually given in return for the transfer of funds. The loan may not be considered bona fide debt by the IRS if it seems that the intention was that the loan would not be repaid, despite the note.
How to overcome the gift presumption
The presumption by the IRS that an intra-family loan is a gift can be overcome by making an affirmative showing of a bona fide loan with a “real expectation of repayment and an intention to enforce the debt.” There are several factors that are considered by courts in making this determination:
(1) existence of a note comporting with the substance of the transaction,
(2) payment of reasonable interest,
(3) fixed schedule of repayment,
(4) adequate security,
(6) reasonable expectation of repayment in light of the economic realities, and
(7) conduct of the parties indicating a debtor-creditor relationship.
As one court determined “[t]he mere promise to pay a sum of money in the future accompanied by an implied understanding that such promise will not be enforced is not afforded significance.” Merely documenting the loan transaction is not sufficient to overcome the gift presumption, for Federal tax purposes.
When is a gift better than a loan?
There may be situations where making a loan to your children may not be the best option. In some cases, making it a gift would be more appropriate. Some situations where a gift may be the preferable choice include the following:
- the lender does not need the funds to be returned;
- the lender does not need cash flow from the interest on the loan;
- how the loan will ever be repaid is not apparent; and/or
- the lender does not plan on collecting the loan.
Can I forgive the loan later?
Although the intention to forgive an intra-family loan can result in the IRS treating the loan as a gift at inception, it really depends on when that intention to forgive arises. The main factor in making this determination is whether there was a prearranged plan to forgive the debt, or if that intention did not arise until a later time. If that is the case, the IRS will not consider the loan a gift until the time it is actually forgiven.
If you have questions regarding intra-family loans, or any other financial or estate planning needs, please contact me at Anderson, Dorn & Rader, Ltd., either online or by calling me at (775) 823-9455.