With today's house prices, this is an increasingly probable scene - your son and his wife come over for dinner, fill the air with friendly chitchat, and finally mumble sheepishly what's really on their mind: They've found their dream house and need help with the down payment.
No, they're not so brash as to ask for a $20,000 gift. Just a loan. A loan with very lenient terms - like no interest and an extremely flexible repayment schedule.
As you discuss the request, be aware that Uncle Sam may want to horn in on this congenial family scene. The government's interest in intrafamily loans stems from having been burned by no-interest loans designed to dodge taxes. Wealthy parents could "lend" money to a child in a low tax bracket and, in the best of income-splitting traditions, the child would invest the money so the income would be taxed at the child's lower rates. That loophole has been closed.
The law now treats such loans as though the lender is charging interest on the deal and simultaneously making a gift to the borrower of the amount needed to pay that interest. This fiction has a very real tax consequence: The lender has to report as taxable income the phantom interest the loan did not produce. What's more, if the amount of foregone interest exceeds $11,000, the lender may be liable for federal gift taxes.
Don't turn down your kids' request straightaway, though, because - as usual - there are exceptions that can protect your intrafamily loan from the IRS.
If the amount of the loan outstanding at any time is $10,000 or less, the IRS will ignore it. Under that test, husband and wife are considered to be one lender and the $10,000 limit applies.
A second exception protects even bigger low-interest or even interest-free loans. For loans up to $100,000, the IRS won't get involved as long as the borrower's investment income is less than $1,000. If it goes over $1,000, the forgone interest to be reported by you and deducted by the borrower is limited to the amount of the borrower's investment income.
In other words, you can go ahead and lend your children $20,000 interest-free for their down payment, but they'd better use most of their own savings, too. If their investment income for the year surpasses the $1,000 threshold, your friendly arrangement could be stung by the imputed-interest rules. Both the $10,000 and the $100,000 exceptions are voided if the purpose of the loan is to save taxes.
If the borrowed funds are used to acquire income-producing assets, for example, the loan automatically falls under the imputed-interest rules. That doesn't block loans for such purposes as a house down payment, college tuition, or to help a child start a business.
If you make a loan that fails to meet one of the exceptions, the amount of imputed interest on the deal is based on IRS-set rates that reflect what it costs the government to borrow money. These "applicable federal rates" are adjusted periodically. Call your local IRS office or go to the IRS Web site to learn the current AFR. If you charge a low interest rate, rather than no interest, the imputed interest is the difference between what you actually charge and the amount due using the prevailing applicable federal rate.
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