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Family Loans: Does the IRS Care If I Lend My Kids Money?

Personal Finance Taxes

As a parent, there’s a chance you may lend your kids money throughout life. Maybe it’s to buy a bicycle, to get their first car, or even to purchase their very own home.

A mom lending money to her child

But, when you fork over cash to your family, does the Internal Revenue Service (IRS) care about those loans?

For small loans, the answer is simple — no. The IRS isn’t concerned with most personal loans to your son or daughter. They also don’t care how often loans are handed out, whether interest is charged or if you get paid back.

But, as with most things, there are exceptions to that rule.

Interest-free loans

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 say the interest you should have charged was a gift. In that case, the interest money goes toward your annual gift-giving limit of $15,000 per individual (increasing to $16,000 for tax year 2022). If you give more than $15,000 to one individual, you are required to file a gift tax form.

The rate of interest on the loan must be at least as high as the minimum interest rates set by the IRS.

Family loans that are really gifts

Some people may think they can give large amounts of money to their children and call it a loan to avoid the hassle of filing a gift tax return, but the IRS is wise to that.

The loan must be legal and enforceable. Otherwise, it 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 back, the rate of interest, and any collateral or security. Both parties should sign the note, and keep a copy in a safe place.

For large loans or ones attached to real estate, seek legal counsel to make sure you’re taking the right steps.

Student loans for tuition

You can give “student loans” to your kids by drawing up a contract like any other loan.

When they graduate and start making payments, your children can take the student loan interest deduction on any interest paid to you. You will have to pay taxes to the IRS on that interest income.

Take a bad debt deduction if your child doesn’t pay you back

One of the advantages of a loan contract is that if your child doesn’t pay, you can take a deduction for a non-business bad debt.

Additionally, you don’t have to pay gift tax to the IRS on the amount you would have if you had gifted the money.

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. The statement should also include a reason for why they are unable to make the payments.

Filing a gift tax return for a loan

In most cases, you won’t have to pay taxes for a “loan” the IRS deemed a gift.

You only owe gift tax when your lifetime gifts to all individuals exceed the Lifetime Gift Tax Exclusion. For tax year 2021, that limit is $11.7 million (increasing to $12.06 million in 2022).

For most people, that means they’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.
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