Neither a Borrower Nor a Lender Be — A Good Idea? Sometimes it seemed like a good idea at the time. That is, loaning your son and daughter-in-law some money as a down payment on a new home. It’s all in the family, so you decide it would be awkward to have them sign a promissory note. Or perhaps they are representing to their mortgage lender that the source of their down payment is really a gift, and maybe you are even asked to sign a declaration of gift so that they qualify for a mortgage loan. A Bad Result? Things don’t always turn out as intended. Suppose you “loan” them $50,000 but you die unexpectedly before the loan is paid back. There would now be a genuine issue as to whether this loan should be repaid to your estate. Obviously, if you have other children who haven’t received a similar loan, their expectation would be that the loan should be collected from the borrowers. Yet, your son and daughter-in-law may not have the capacity to pay it back, and they may resent it being offset against their share of your estate. A Civil Solution? Of course, the civilized way for civil people to address differing points of view in our blessed country is to hire bulldog attorneys. That way, after the legal fees are paid, there is nothing left to fight about, and consequently all is well in the state of Denmark! All’s well that ends well, right? Unfortunately, things didn’t end so well, now that this legal dispute has triggered hostility across family bloodlines. Your children no longer speak to each other, and your grandchildren miss their cousins, whom they no longer see. Good Intentions. Naturally, you anticipated none of this when you innocently made that loan. You were trying to do a good thing. You didn’t even ask for interest on the loan. Unfortunately, this latter point captures the attention of the Internal Revenue Service. The mission of the IRS is to penalize people for making money, accumulating wealth and giving it away, whether during their lifetimes or at death. IRS Involvement. The IRS requires that loans of more than $10,000 bear a reasonable rate of interest (currently a little over 5%). If they don’t, the IRS is kind enough to “impute” interest income to the lender, which means they pretend you receive interest income. However, rather than just pretend to tax the income, they expect you to actually report the interest income as taxable on your annual return. Also, since you are actually foregoing payment of interest, they treat that interest payment which you are not getting as a taxable gift back to the borrower. If you’ve already used up your $12,000 per year annual gift tax exclusion for the borrower, then this gift cuts into your $1 million lifetime gift tax exemption, as well as your $2 million lifetime estate tax exemption. And if you’ve already used up your lifetime exemption, you must pay gift tax on the foregone interest. Forgive and Forget. Perhaps a number of years go by, and you decide to forgive the loan before you die. The IRS treats that debt forgiveness as a gift that might be subjected to gift tax. In fact, the IRS might even treat the loan as a gift right from the start by presuming you never intended to have it repaid. Guarantees. Even if you merely guarantee your child’s loan, the IRS may under certain circumstances treat the guarantee as a gift, the value of which may vary case by case. What to do? In light of the above litany of pitfalls and problems, here’s what you can consider doing: Rule #1. Don’t loan money to family members. Rule #2. If you violate Rule #1, make sure there is written documentation for the loan:
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