Gift Loans

Family members with assets or cash often consider making loans rather than gifts to other family members with financial needs, for one or more of several possible reasons:

• The financial need may be temporary, and the borrower may be able to repay the loan at a future date, so a gift is not necessary.
• The lender may expect to need the funds for his or her own financial needs at a later date.
• Although it is usually older family members who are thinking of providing financial support for younger family members, it is sometimes the other way around, and one or more children may be asked to provide financial assistance to a parent. In that case, a gift might not be not desired because the child providing the financial support might be one of several children and a gift might increase the inheritances of the other children (which is not what is intended), or because the child (or children) might have to pay estate or inheritance taxes when the parent dies and they inherit back the same money that was a gift to the parent.
• The lender might have already used up their federal estate tax or state estate tax exclusion, and may not want to pay any gift tax.

However, an intra-family or other gratuitous loan may have income tax and gift tax consequences if the loan is not made with a market rate of interest. This is because section 7872 of the Internal Revenue Code imputes interest to "gift loans" that have a rate of interest that is less than the "applicable federal rate," which is the rate of interest that can be earned on federal securities with comparable terms.

For loans for a stated term, the difference between the principal amount of the loan and the present value of the loan payment, calculated using the applicable federal rate, is a gift when the loan is made. For federal income tax purposes, the "foregone interest" (the difference between interest at the applicable federal rate and the interest actually payable) that is realized each year is considered to have been paid by the borrower and received by the lender in that year. (There are different rules for loans that are payable on demand and not for a stated term.)

There are exceptions and qualifications to these rules:

• These rules do not apply when the total amount of the loans between two people is $10,000 or less (but only if the loans are not used to purchase income-producing assets). For this purpose (and the purpose of the $100,000 limitation described below), a married couple is considered to be one person.
• When the loans between two people do not exceed $100,000, the foregone interest that is realized by the lender is limited by the borrower's net investment income (and net investment income of less than $1,000 is considered to be no investment income).
• If the making a loan results in a gift, the gift can qualify for the federal gift tax annual exclusion (which is $17,000 in 2023).

Therefore, before entering into a intra-family loan for a term, it is desireable to determine whether there will be a gift when the loan is made, and the amounts of foregone interest that may be realized each year.