As I blogged about back on September 14th many first-time hombuyers have received gifts or loans from family members over the past year so that they can take advantage of historically low interest rates, affordable housing prices, and the government’s tax credit. The onslaught of familial generosity is great for homebuyers who would otherwise be unable to buy a home. However, I get the impression that many of the parents and grandparents who are making gifts or loans are doing so haphazardly without consulting their tax advisers. Furthermore, most mortgage professionals are not properly schooled in this topic and are not providing adequate guidance to the parties involved. As a result I foresee many people getting a surprise when it comes time to file their tax returns.
Back on September 14th I covered the gift tax rules for those who make an outright gift to others. However, I also want to cover loans.
In general loans to family members (or anyone else) are not considered gifts when a reasonable interest rate is charged. However, there are gift tax implications when “below market” or “interest free” loans are made. In this instance the IRS will require that the lender recognize the “imputed interest” as a gift to the recipient of the loan. “Imputed Interest” is the term used in the IRS tax code to describe interest considered to be paid for income tax purposes, even though the interest payment was not actually made. You can think of it as phantom interest. The imputed interest is included in the lender’s income even though the lender did not receive any money. Furthermore, the lender is also considered to have made a gift to the recipient in the amount of the imputed interest. If the funds are used as acquisition indebtedness to purchase a home then often times the recipient will be able to deduct the imputed interest as mortgage interest even if they didn’t actually pay it.
Imputed interest is based on the loan amount and is calculated by taking the difference between the actual interest collected on the loan and the “Applicable Federal Rate” (AFR) which is the rate the IRS deems as the market rate. AFR can be accessed at this link and varies depending on the term of the loan.
If a loan was for $10,000 or less then there is no imputed interest and no gift tax implication.
If a loan amount of $10,0001-$100,000 is made then the imputed interest is the lesser of the net investment income of the recipient in that year (if the recipient’s net investment income is less than $1,000 then imputed interest is deemed to be $0) or the difference between the actual interest collected and the AFR.
If the loan amount is in excess of $100,000 then the imputed interest is the difference between the actual interest collected and the AFR.
It is always wise to discuss your gift giving or generous loan plans with a tax adviser or estate planner before writing the checks. There is significant flexibility in the gift and estate tax code to allow most households to escape tax liability but it may require some careful planning.