No Such Thing as an Interest-Free Loan
By: Patricia T. Henssler, C.P.A.
The Henssler Financial Group Position Paper
As far as the IRS is concerned, there is no such thing as an interest-free loan. Loans without interest, or at below-market interest rates, are recharacterized so that the lender must recognize market-rate interest income.
These loans are treated as a loan bearing a market rate of interest that is paid by the borrower to the lender, coupled with a transfer of funds from the lender to the borrower that is used to pay the interest.
You can get in trouble on two fronts — by not reporting enough interest income and perhaps by violating the gift tax rules.
You can gift as many people as you wish, $12,000 (indexed) annually, without filing a gift tax return or paying gift tax, but if your gift to any one person exceeds $12,000, you are required to file a gift tax return and either use part of your lifetime exemption or pay gift tax (see related article, "Gift Tax Returns").
A below-market loan is any loan that bears interest at a rate less than the "applicable federal rate" (AFR). The AFR is a rate of interest that is periodically revised and tied to the rate on U.S. Government securities with maturities comparable to the loan in question (monthly tables are available from the IRS). For instance, if you made a 10-year loan to someone in January 2002, with semi-annual compounding, you would have needed to charge at least 5.39% interest; otherwise, it would be considered a below-market loan.
In the case of a gift loan or demand loan (no stated term for maturity), the IRS provides a simplified method of computing the foregone interest. This is called the "blended annual rate," and can be used to compute the interest on the loan for the applicable year. The "blended annual rate" for 2007 is 4.92%. It is assumed that this interest is calculated and paid on December 31 of each year.
Typical Gift Loan
On January 1, 2007, you "loaned" your child $50,000 for the down payment on their house. You are not "charging" them interest. You still earned interest as far as the IRS is concerned. Based on the 2007 blended annual rate, you are required to report $2,460 of interest income. Further, you are treated as gifting your child $2,460 to turn around and pay you the $2,460 of interest. In the case above, if the proceeds of the loan can be traced to the home purchase, the interest "paid" can be deducted as mortgage interest. If you had loaned them the money to buy furniture or a car the interest would not be deductible, as it would be considered "personal interest." However, in all cases, you are required to report the interest income.
Where can you get in trouble on the gift tax side? Suppose you gifted your child $10,000 and "loaned" them $60,000 to avoid the gift tax rules? The $60,000 loan would have required another gift on December 31st of $2,952 to pay the interest. This would have been a total gift for the year of $12,952. You would be required to file a gift tax return, and either use part of your lifetime exemption for the excess $952 or pay gift tax.