Helping a family member when they need a financial assistance is a noble work. But your nobility can cause you to pay a significant amount on taxes as either an income tax or a gift tax. It may sound weird but true. If you do not believe, read on to know what experts have to say in this regard.
The situation arises when you make a personal loan with a zero interest. The US tax rules are fairly complicated and hard to understand unless you have an attorney or a financial adviser by your side. An interest-free unsecured loan may classify under a gift and the repayment you receive from the borrower may be treated as your income. Thus you are likely to face unfavorable tax rules.
How to avoid taxes on such personal loans
Well, the solution is to avoid making a totally interest-free personal loan to a family member.
To elaborate it further, you need to play the role of a typical lender by charging an interest rate. The rate of interest must at least equal the IRS-approved applicable federal rate (AFR). The AFRs for term loan are updated monthly and one can have the latest rate structure from the website of Internal Revenue Service (irs.gov). To your pleasant surprise, these rates are unbelievably low as you can see the following rate structure for June, 2017.
- Short Term (up to three years): 1.18%
- Mid Term (over three years but up to nine years): 1.94%
- Long Term (over nine years): 2.65%
The above interest rates are good for term loans with a defined repayment schedule or a specific balloon payment due date and are applicable for the entire term. Be sure to check the current rate at the IRS website.
On the other hand, if you are making a demand loan with the flexibility to demand repayment at any time, you must charge a floating rate based on the changing AFRs. A floating rate option may be a better choice if the loan being advanced is for a short duration. However, if you are making a personal loan for a significantly long duration, it is prudent to consider making it a term loan.