Interest-free loans are a favorite way for better-off family members to help others with financial needs — such as parents helping children to buy a home or start a business… or one sibling helping another out of a scrape.

And especially in today’s market of low interest rates for savers and high credit hurdles facing borrowers, even family loans made at normal interest rates often can benefit both lender and borrower by giving each better terms than would otherwise be available — while keeping interest payments within the family.

Opportunities with family loans and traps to avoid…

NO-INTEREST LOANS

An interest-free loan allows one to give a gift to the loan recipient (the lack of interest) while retaining the legal right to be repaid the loan principal.

If you are the giver, this can provide important financial security compared with simply making an outright gift of funds if it turns out that you need the money in the future. If you lend funds to, say, your grown child, the loan even can be secured by the child’s home or business or other assets — so if you need the funds later, you can get them back.

Complication: To prevent interest-free and below-market-rate loans from being used abusively by families to avoid tax, Congress has made them subject to so-called “imputed interest rules.” Under these rules, such loans are treated as if they carry interest at an “applicable federal rate” (AFR) determined by the IRS.

Example: A parent makes an interest-free loan to a child that is subject to imputed interest rules. The AFR for the loan is 4%. The parent has “imputed” taxable interest income as if receiving 4% interest on the loan — even though no interest is actually received. This interest must be reported as income by the parent.

Similarly, if interest on the loan would be deductible under normal rules (such as with a mortgage loan), the child can deduct imputed interest as if paying 4% interest on the loan.

To learn if an interest rate is “below market,” check the IRS’s AFR tables, published monthly, at the IRS Web site (www.irs.gov). Type “AFR table” into the search box.

Example: In June 2008, IRS AFRs ranged from 2.08% to 4.46%, depending on the term of the loan.

TAX-AVOIDANCE STRATEGIES

Fortunately, it’s easy to arrange for most interest-free family loans to escape the imputed interest rules.

These rules do not apply when all of the lender’s below-market-rate loans to a recipient do not exceed…

  • $10,000, and the loan amount is not invested to produce income.

    Example: You loan $7,000 interest-free to a child who spends it on a new car. There is no imputed interest.

    However, if the child spends only $2,000 of the loan (perhaps on the car down payment) and deposits $5,000 of it in an interest-earning savings account, there will be imputed interest. It will equal the lesser of the savings account interest actually earned on the $5,000, or the interest on $5,000 calculated using the appropriate AFR.

  • $100,000, if the recipient does not have investment income exceeding $1,000.

    Example: You make a long-term interest-free loan of $95,000 to help the child start a business. If the child does not have investment income of more than $1,000, there is no imputed interest.

    But if the child has interest and dividend income totaling $2,500, the $1,000 limit is exceeded and there is imputed interest on the loan. It will equal the lesser of $2,500 or the amount determined using the appropriate IRS AFR.

    Gift tax: Forgone interest on a loan is also considered a gift that may be subject to gift tax.

    Saver: You can make gifts of up to $12,000 per recipient free of gift tax each year. Thus, using the current highest AFR of about 4.5%, a gift of more than $12,000 of interest would result only from loan principal of about $270,000 or more.

    Planning: If you intend to make a below-market-rate loan to a family member…

  • Keep the loan amount below the $10,000 or $100,000 limits.

  • Have the loan recipient use the funds in some way other than investing them for income.

    Examples: To buy a home… start a business… buy household goods… pay down debts.

  • Use a “demand loan,” one repayable upon the demand of the lender rather than at a fixed maturity date.

    Why: Demand loans are considered “short term” by the IRS, so they have low AFRs. This reduces the problem should a loan be deemed by the IRS to be subject to imputed interest (perhaps because the recipient is found to have investment income over $1,000).

INTEREST-BEARING LOANS

Today, even loans made at “regular” interest rates often can help the borrower, the lender, and the family as a total entity.

Simple case: A retired parent has funds in a savings account or a money market fund earning as little as 2% interest, or even less. A child, perhaps just out of college or starting a family, has a few thousand dollars of debt on a credit card at 15% interest. The parent can lend money to the child to help pay off the credit card debt, perhaps at 6% or 7% interest.

Result: The parent receives more interest income than before… the child pays less interest than before… interest currently being paid to the credit card company stops leaving the family.

KEYS TO LOAN PLANNING

Strategies for both low-interest and regular rate loans…

  • Gift making. Even if you intend to make a gift to the recipient from the start by planning to forgo repayment, you may want to structure the transaction as a loan to avoid adverse gift-tax consequences.

    Hurdle: If you give more than $12,000 of funds to an individual in a year, the excess over $12,000 is a taxable gift.

    Strategy: Structure a large advance of funds as a loan to avoid gift tax. In later years, make gifts of up to $12,000 annually by forgiving that much of the loan amount each year.

    Example: You want to give your daughter $100,000 to start a business. If you give her the whole amount outright, it will be a taxable gift. Instead, make it a loan. Then you can forgive $12,000 of the loan. The remaining loan amount will be $88,000. The next year, forgive another $12,000, leaving $76,000 on the loan. Continue in $12,000 increments each year until the loan disappears.

  • Protect use of funds. Since the option to convert a loan to a gift is up to you, you can use your willingness to do so (or not do so) to influence the recipient to use the funds wisely.

    If the recipient makes best use of the funds, you may choose to convert them to annual gifts. If not, you may choose to maintain repayment of the funds through the loan terms.

  • Secure a risk-minimizing deduction. A loan can also entitle you to a bad debt deduction if it isn’t repaid.

    Example: If you use a loan to help a child start a business, you’ll be entitled not only to repayment if the business succeeds but also to a bad-debt deduction if the business fails and the loan is not paid as a result.

    Important: To ensure that an advance of funds will be treated by the IRS as a loan and not a gift, meet all of the legal requirements for a loan. Have a note specifying the loan’s term, interest rate and repayment schedule, and consider establishing security as well. For loan contract forms and other details on how to set up a family loan, check the Lendingcircle.com Web site (www.lendingcircle.com).

    If the intrafamily loan is for a mortgage, it must be legally secured by a residence.

    If a loan to a family member goes unpaid and you wish to obtain a bad-debt deduction for it, you must make a formal demand for payment and take other steps that a creditor would take.

    If you fail to formalize the loan or its terms aren’t followed — for instance, payments aren’t made on it — the IRS may deem the entire loan amount to really be an intrafamily gift, and possibly a taxable one.