Imputed Interest, Gifts and Family Loans

Family Loans are an integral part of life, as well as estate and gift tax planning.  Until the IRS victory in Dickman in 1980, interest-free loans were a staple of tax planning. Today, however, the rules that apply are designed to force interest income to be reported, even if not paid.  Certified Public Accountants (CPAs) encounter these rules in preparing returns and must comply. Those familiar with the topic know that a complete discussion is beyond the scope of a blog, but here are some common misunderstandings.

The first issue is whether the loan is a term loan or a demand loan.  Invariably, family members do not execute notes reciting interest rates, so CPAs are forced to apply the demand loan rules. Each year, the IRS publishes an interest rate in January and again in July with each rate applying for six months. If the loan remains outstanding, the taxpayer may use a blended rate to calculate the interest that must be reported. Where the taxpayer does not keep good records, it is especially difficult to address the issues after the death of the taxpayer and to prepare an inheritance or estate tax return. Was it a gift or are the income tax returns wrong.

What makes matters more difficult is that the borrower, typically a child, sometimes pays irregularly. Fortunately, the rules provide that each payment reduces the balance and a new loan is created on the following day using the “exact” or “approximate” method.  Once again, the process requires record keeping which is beyond the reach of many individuals.

The duration of a term loan causes an appropriate rate of interest to be assigned by IRS. Where taxpayer’s interest rate is below the rate required by IRS, Original Issue Discount (“OID”) must be charged. The lender’s income tax return not only must report income but also must recite five (5) items in a statement attached to the return.  The borrower’s return must contain a similar statement. Despite the fact the rules have been around for years, most taxpayers do not realize that OID applies to cash-basis taxpayers.

Below market term and gift loans require the lender to report the forgone interest as a gift on the last day of the year. Loans with adequate interest do not have to report forgone interest; however, accrued but unpaid interest requires OID reporting.

Sales of property for less than fair market value pose a problem. Is the transaction a gift of the bargain portion or is it a below market loan? When the present value of the payments is less than the face value of the loan, it is OID. This is, perhaps, the most overlooked issue in tax.  The tax preparer’s nightmare is when the value, appraised or not, undervalues the gift. Not only are there estate and gift tax consequences, but also there are income tax.

No where does this area become more obtuse than an interfamily installment sale to a child of property to be used in business.  Many contend that §483(e) applies exclusively and application of §7872 is precluded by §7872(f)(8) and the  Frazee  case.   Yet for all the complexity, no one can deny that loaning funds to a child to buy a house or start a business.  Funds loaned today on a ten year loan at 3.3% may transfer substantial wealth over the long term.  Despite the rules, family loans have substantial benefits.