From a tax perspective, gifts and loans are straightforward. But when the interest rate of a loan falls below the market rate of interest, you may have a gift loan on your hands!
A gift occurs when property is transferred from one party (the donor) to another (the donee) for no consideration. The tax consequences depend on the value of the gift. Individuals receive both an annual exclusion ($14,000 in 2015) and a lifetime exclusion ($5,430,000 in 2015 and indexed for inflation annually) for gifts. You must file a gift tax return if you gave gifts totaling more than the annual exclusion amount to someone in a calendar year. In the case of a gift greater than the annual exclusion amount, the lifetime exemption is then applied. Once the lifetime exclusion is exhausted, gifts greater than the annual exclusion are subject to the gift tax (currently 40%).
There are, of course, more intricate rules (such as rules for generation-skipping gifts) and exceptions (such as transfers to your spouse, direct payments of education or medical expenses on behalf of a donee, and political contributions) that add complexity, but identifying a gift is relatively easy, and keeping gifts to any one person under the annual exclusion amount reduces the tax filing burden. Remember, even if there is no tax on a gift over the annual exclusion amount due to the lifetime gift exemption, you still must file a gift tax return in order to track the remaining lifetime gift exemption. Just as important to remember, the lifetime exemption for gifts and the estate tax exclusion are one in the same; any amount you use during your lifetime reduces the estate exemption applied to your estate!
A loan occurs when property is transferred from one party (the lender) to another (the borrower) under the terms of a contract which requires repayment of the principal value of the property loaned plus interest. The tax code identifies two types of loans: a demand loan and a term loan. A demand loan is payable in full at any time on the demand of the lender. Interest may be paid periodically while the loan is outstanding, or compounded and added to the demand principal, depending on the terms of the loan contract. A term loan is any loan other than a demand loan. Term loans generally have set parameters, similar to your mortgage or an auto loan. Both demand and term loans can have unlimited terms, features, or covenants, whatever is negotiated by the lender and borrower. Generally, the lender recognizes interest income annually from the loan.
And here’s where it gets tricky. Section 7872(f)(3) of the Internal Revenue Code states, “The term “gift loan” is any below-market loan where the forgoing of interest is in the nature of a gift.” Essentially, if you lend property at a rate below the applicable federal rate (AFR) published by the IRS, the difference between the AFR and the loan rate is considered a gift. The AFR is meant to reflect a fair market rate of interest that independent parties would negotiate in an arms-length transaction. From a tax perspective, the AFR eliminates preferential treatment between related parties by applying a minimum market rate of interest. AFRs are published monthly, and different AFRs will apply to different loans, depending on the term of the loan. In general, the longer the term of the loan, the higher the rate that will apply (just as in the marketplace).
By lending at a below-market rate, you are forgoing interest that the borrower would pay in the marketplace, resulting in an imputed gift for tax purposes. The most common occurrence of gift loans is intra-family loans, but the imputed gift rules in Section 7872 apply to any below-market loan, such as compensation-related and corporation-shareholder loans, below-market loans with the purpose of avoiding federal tax, interest arrangements which have a significant effect on either the lender’s or borrower’s federal tax liability, and certain loans to qualified continuing care facilities. As you probably guessed, there are exceptions. Aggregate outstanding loans under $10,000 receive a de minimis exception if the loans are between individuals and not used to purchase income-producing assets. There are also special rules that consider the borrower’s net investment income and limit the interest accrual when aggregate loans between individuals are under $100,000.
In addition to the imputed gifts generated by gift loans, the lender must recognize interest income in the amount of the forgone interest. This ensures that the full amount of market interest as determined by the AFR is being recognized as income.
Whether it’s a gift, a loan, or a gift loan, it’s critical to carefully structure transactions in a manner designed to meet your goals. Proper planning is especially important in intra-family loans, which will affect annual income taxes, gift taxes, and ultimately estate taxes. Depending on your specific needs, you may or may not want to make imputed gifts through gift loans. Choosing the right rate, term, and structure (demand versus term) of the loan will be what determines if you are able to efficiently meet your goals and avoid unintended income and gift tax.
The experts at WithumSmith+Brown can perform a comprehensive review of your estate plan to keep you on track to meet your family’s goals. If you have any questions or would like to further discuss this matter further, please contact a member of Withum’s Estate and Trust Services Group at firstname.lastname@example.org.