Tax Strategies for Lending Money
If wise tax strategy and investing has led you to be financially better off than a close friend or relative, your natural inclination may be to lend them money interest-free in their time of need. However, this is generally a poor tax strategy. If you don’t charge interest, the IRS might charge your beneficiary income tax on the loan, which would not be a good tax strategy for them either. Even worse for you, you may be required to give the IRS the difference between what you charged in interest (which may have been nothing at all) and the current minimum interest rate. And worse still, an extremely large interest-free loan (such as one over $13,000 from an individual who has already given away $1 million or more) may be subject to the gift taxes you thought you had circumvented through other tax strategies.
Instead, make the loan more like a business proposition. Only lend to someone with the ability to pay back the principal and interest. (If your son or daughter needs a helping hand, there are other ways to transfer money to them, such as a trust fund.) Draw up a legal contract for purposes of tax documentation. Having a contract is a common-sense financial strategy as well as a tax strategy; there is often a strong correlation between having one’s name on a contract, even if it is being held by a family member, and actually repaying the loan.
Do these guidelines apply to lending your deadbeat cousin $500 to pay the rent? No, they do not. The interest requirement only applies to loans of $10,000 or more, and if the recipient’s investment income is less than $1,000, the ceiling is raised to $100,000. Thus, make sure that cousin doesn’t put the interest-free $20,000 you lend him to make the down payment on a mortgage into the stock market instead. If this happens, the IRS’ tax strategy will be to tax you on either the minimum interest rate when you loaned the money or the borrower’s own investment income, whichever is smaller.
Consult your financial planner for the proper tax strategies to use when loaning money to family members. If you could have invested the funds you are loaning out, then you are losing potential interest on them, making it even more important for you to charge an interest rate that doesn’t impede your own finances. If you follow the same basic tax strategies as a for-profit lender, while not subjecting your loved one to an extortionate interest rate, the loan could have beneficial financial ramifications for them as well as keeping you in the clear tax-wise.