Here’s scenario that is becoming more common in our current low-interest rate environment:
A son has run into to some credit card debt. Mom and Dad have a $25,000 CD coming due and are staring at a 1-1.50% interest rate for its renewal. Mom and Dad decide to lend $25,000 to their son to help him get out of high-interest debt. Mom and Dad want to call it a loan and charge interest of 3% (twice the amount they would get on the C.D.).
This sounds like a great solution to an all too common problem. There are potential pitfalls that you want consider before entering into a transaction like this:
Lack of Documentation:
In order for this to be truly considered a loan you will want to have a signed loan document with the interest rate and repayment schedule. The IRS tends to treat you more favorably when something is written down.
Inaccurate Tax Reporting:
If their son reports interest expense from the loan on his taxes Mom and Dad better report the corresponding interest income on their return.
Mom and Dad tend to be a little more lenient than your average bank. A series of skipped payments or overall loan forgiveness can turn the loan into a gift in the minds of the IRS. This can create adverse tax consequences down the road.
Not charging enough interest:
The IRS sets an AFR (Applicable Federal Rate) which sets the acceptable rates for loans. If you don’t charge enough, the lender may be taxed on imputed interest (the difference of what they should have received and what they actually did) and gift tax consequences may come into play.
Smaller loans (under $10,000) may avoid some of these problems, but in general it wise to consult a CPA and/or estate planning attorney before entering into a family loan arrangement.