Family can take so many different forms these days, whether it’s biological or otherwise, but for a certain segment of my clientele, there is a particular privilege that might kick in this week:
The parent tax.
If you have children, what better way to teach them about the realities of our taxation system than by skimming 25% of their collected Halloween candies and setting them aside?
Shoot, you could even get creative and do some “parent tax planning” — i.e. making proactive plans with your children about particular kinds of candies that are subject to greater tax, and others that can be collected tax-free (in my opinion, anything “Reeses” should be double-taxed, but that’s just me).
Just giving you some #ideas. 🙂
But there’s another “privilege” that occasionally presents itself among family and close relationships, that can bear unplanned consequences — that is, unless you do it right.
Lending money to family members.
Yikes. Let’s dive in.
Emelia Mensa CPA’s Guide for Lending Money to Family Members
“Families are the compass that guides us. They are the inspiration to reach great heights, and our comfort when we occasionally falter.” – Brad Henry
Individuals who are strapped for cash and in a pinch often look to family members for help, and rightfully so — your immediate family has been with you since day one, and to ask a friend (even a really good one) for money can be uncomfortable with too much that can go wrong.
But there are a few tax ramifications you should know before cutting a check to those closest to you. And if you have any further questions after the following points, please do not hesitate to call and ask.
Family Is Informal
Often, transactions between family members are informal and not properly documented (the agreements don’t have an interest rate or require regular payments). Parents or grandparents who offer a loan often won’t hold the recipient to a payment schedule (depending on the severity of one’s financial troubles).
But according to tax rules, sharing within family presents a conundrum. Any family loan payment without an interest rate is charged as income to the parent from the child. Therefore, the interest is accumulated through that “income” and parents or grandparents are responsible to report interest income on their taxes.
It’s important to note, in 2019, that parents or grandparents can classify the loan as a “gift” up to $15,000. And a married couple can give a total of $30,000.
A Formal Agreement
To keep things from getting tricky on the tax side of things, please consider a formal, written agreement when sharing money between family members. (I can help answer questions for you on this process.)
In short, the document should include an agreed-upon (IRS-approved) interest rate depending on how long the loan exists — monthly, quarterly, etc.
The borrower should make these payments on a regular basis. If he or she does not, then the IRS could question if the loan was really a loan in the first place, and might count the amount as a gift in sum.
Two important rules on imputed interest:
- A loan less than $10,000 is tax-exempt — that small of an amount isn’t something the IRS will fret over.
- However, loans over $10,000 are a little different. Parents or grandparents that offer such a larger loan have the ability to report imputed interest at a lower federal rate.
A Real Life Example
Take (fictional) Billy and his (fictional) parents: Scott and Karen.
Billy wants to buy a home, and Scott and Karen would like to help him with the down payment. They give Billy $100,000 and charge 3.22% interest — the approved interest rate at the time compounded semiannually.
An option for Billy is to count the loan as a second mortgage on his home. That way, he could potentially deduct imputed interest on his tax return. Scott and Karen’s loan to Billy is a nice gesture, but hurts them financially in the long run. They could have received investment income on the loan paid to Billy, and now it will reflect on their income taxes through imputed interest.
But the real problem for this family of three, and your family should a similar situation arise, is when things are not formally documented and agreed upon. A quick internet search will provide a loan agreement form, or I can guide you in the process.
The key is over-communication and filing away the information correctly. Nothing in life is guaranteed, and if you write down important information within the context of a family loan, then you might prevent problems for others down the line.
Helping family is a good thing. But even though I’m biased, making sure your taxes are squared away is nearly just as good.
Emelia Mensa EA, CPA
Emelia Mensa CPA