Suppose your adult child or friend needs to borrow money. Maybe it’s to buy a first home or address a cash flow problem. You may want to help by making a personal loan. That’s a nice thought, but there are tax implications that you should understand and take into account.
GET IT IN WRITING
You must be able to support that you intended to make a loan rather than a gift. That way, if the loan goes bad, you can claim a non-business bad debt deduction for the year the loan becomes worthless.
For federal income tax purposes, losses from personal loans are classified as short-term capital losses. You can use the losses to first offset short-term capital gains that would otherwise be taxed at high rates. Any remaining net short-term capital losses will offset net long-term capital gains. After that, the remaining net capital losses can offset up to $3,000 of ordinary income per year ($1,500 if you use married filing separate status).
To support the loan for the IRS, your loan should be evidenced by a written promissory note that includes:
- Interest rate
- A schedule showing dates and amounts for interest and principal payments, and
- Security or collateral for the loan
SET THE INTEREST RATE
Applicable federal rates (AFRs) are the minimum short-term, mid-term and long-term rates that you can charge without creating any unwanted tax side effects. AFRs are set monthly by the IRS. For a term loan (meaning one with a specified final repayment date), the relevant AFR is the rate in effect for the duration of the loan.
INTEREST RATE AND THE AFR
The federal income tax on a loan is straightforward. As the lender, you must report the interest income on your Form 1040. If the loan is used to buy a home, your borrower can potentially treat the interest as deductible qualified residence interest if the loan is secured with the home. What if you make a below-market loan (one that charges an interest rate below the AFR)? The Internal Revenue Code treats you as making an imputed gift to the borrower. This gift equals the difference between the AFR interest you “should have” charged and the interest you charged. The borrower is then deemed to pay these phantom dollars back to you as imputed interest income. You must report the imputed interest income on your Form 1040.
PLAN IN ADVANCE
As you can see, you can help a relative or friend by lending money and still protect yourself in case the personal loan goes bad. Just make sure to have written terms and charge an interest rate at least equal to the AFR. If you charge a lower rate, the tax implications are not so simple. If you have questions or want more information about this issue, contact us.
