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It is not possible to make loans without charging a "reasonable" rate of interest. The government publishes monthly charts setting forth the average interest rate for certain government securities. If a loan is below market rate, that is the interest is less than that published by the federal government, the lender must report and pay income tax on the annual interest rate which the government publishes.
If someone loans $100,000 to his son and does not charge interest and the government table shows an interest rate of 4.3% for that type of loan, the lender will be taxed on “imputed” interest of 4.3% on the $100,000, or $4,300 for the entire year. This is sometimes referred to as “phantom” interest since the lender does not receive payment, but is still taxed on the imputed interest as shown on these tables.
The tables are divided into sections for loans of 0-3 years, 3-9 years, and over 9 years. Interest rates vary depending upon whether the interest is paid monthly, quarterly, semi-annually or annually. If the current government table for a 3 year loan with interest paid monthly is 4.14%, the taxpayer has income tax problems if he charges less than this amount. The tables can be viewed at several sites on the internet.
There are two exceptions to this rule. One can loan $10,000 to any person he or she wishes, and as long as the loan does not exceed $10,000 and the loan amount is not used to acquire income producing assets, no interest is required. Husband and wife are viewed as one person for loan purposes, so that it is not possible for a couple to loan $40,000 to a son and daughter-in-law. $10,000 is the maximum.
The second exception provides that one can loan a total of $100,000 to someone without interest as long as the borrower's total investment income for the year does not exceed the $1,000. The purpose is to prevent someone in a high income tax bracket from loaning money to a child who is in a lower tax bracket and invests the funds. If the child uses the money to pay off bills, buy a home or purchase other assets, then this will not create a problem. The maximum exception is $100,000. Above that, the government minimum interest rates will apply.
There are numerous special rules and some complicated exceptions. Anyone contemplating an interest free loan or a loan with interest below the current federal rates should consult his or her tax advisor or attorney.
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