You might lend your kids money from the time they are little – to buy a bicycle, to get that first car, or to buy a house.
Does the IRS have anything to do with these family loans?
For small loans, the answer is “no.”
The IRS isn’t concerned with most personal loans to your son or daughter. They don’t care how often you make loans, whether you charge interest, or if you ever get paid back.
However, there are exceptions.
If you loan a significant amount of money to your kids, say, enough to buy a house, it’s important to charge interest.
If you don’t, the IRS can determine that interest you should have charged was a gift. (In addition, the borrower may be more motivated to actually pay you back if there’s interest involved!)
The rate of interest on the loan must be at least as high as the minimum interest rates set by the IRS.
You don’t have to worry about skipped interest being subject to gift tax rules unless the interest you should have charged, combined with other gifts to the same person, exceeds $14,000 in 2013.
Loans that are really gifts
Some people may think they can give large amounts of money to their children and say it’s a loan, thus avoiding the hassle of filing a gift tax return.
The IRS is wise to that.
The loan must be legal and enforceable, or the whole thing may be deemed a gift.
Fortunately, it’s easy to make a loan legal.
Write a note that shows the loan amount, when it will be paid, the rate of interest, and any collateral or security (such as a car).
Have both parties sign the note, and keep it in a safe place.
For very large loans, or for loans attached to real estate, seek legal counsel to make sure you’re covered.
Student loans for tuition
You can make “student loans” to your kids by drawing up a contract like any other loan.
When they graduate and start making payments to you, you will pay tax on the interest income, and the kids can take the student loan interest deduction.
Take a bad debt deduction if your child doesn’t pay you back
One of the advantages of writing up a loan contract is that if your child doesn’t pay, you can take a deduction for a nonbusiness bad debt.
In addition, you don’t have to pay gift tax on the amount, as you would if you had given the money outright.
To take a bad debt deduction, you must prove that you tried to collect the debt.
The debtor should make a written statement that he or she cannot pay, and include a good reason, such as unemployment.
Filing a gift tax return for a loan
If I have to file a gift tax return for a “loan” that the IRS determines is really a gift, will I owe gift tax?
You only owe gift tax when your lifetime gifts to all persons exceeds the lifetime gift tax exclusion ($5,250,000 in 2013).
For most of us, that means we’re safe.
Other family loans that are safe from tax consequences
You don’t have to worry about family loans being subject to gift tax rules if:
- You lend a child $10,000 or less, and the child does not use the money for investments, such as stocks or bonds.
- You lend a child $100,000 or less, and the child’s net investment income is not more than $1,000 for the year.