Financial Tips for Down Markets: Make Low- or No-Interest Loans

The economic decline from the COVID-19 pandemic may have a silver lining for lending: a rapid drop in interest rates. This can make it an ideal time to make low- or no-interest loans to your loved ones while minimizing tax impacts for yourself.

Tax Implications for Low- or No-Cost Interest Loans

It is natural for family members to want to help each other. As a parent, for example, you may want to assist your children in buying a home or car or starting a business. And you may want to do it as a loan rather than giving them the money. Just like many other families, you might even want to charge as little interest as possible or no interest.

While not charging your family members interest on loans might seem like a nice thing to do, you do need to be aware of what is called the applicable federal rate (AFR). This is the minimum rate required by the government, and charging interest below this rate can trigger tax consequences for you, the lender. You can view the current AFR on this IRS webpage.

The IRS can assess imputed interest by calculating the difference between your loan’s interest rate and the AFR. You can then be charged income taxes on the difference, though there are exceptions, as explained on Investopedia.

Plus, charging less than the AFR can affect your annual gift tax exclusion, as the interest that the borrower avoided with the low- or no-interest loan will be considered a gift on your part.

Say you, as a parent, want to help your child buy a home by making a substantial no-interest loan for a mortgage. You could end up exceeding the annual gift tax exclusion (currently at $15,000 for individuals and $30,000 for married couples) with the interest the government believes you should have charged.

Yet you could apply the amount to your lifetime gifting limit and avoid gift taxes. Currently, the lifetime gift tax exemption is $11.58 million for individuals and $23.16 million for couples, though these amounts will decrease to $5 million in 2026 and potentially less in the future.

Why This Can Be a Good Time to Lend Money to Loved Ones

With the AFR at a low because of the COVID-19 economic fallout, you can expect to pay less income tax on the imputed interest that the IRS would levy for charging a loan rate that is less than the AFR.

For example, the April 2020 annual compounding AFR on long-term loans (terms of more than years) is 1.44%. Yet, as of March 26, 2020, the average rate for a 30-year, fixed-rate mortgage was 3.5%, according to Freddie Mac . So loans between family members can provide significantly better terms than market loans, without necessarily having as many tax implications as they might have with a higher AFR.

Plus, making a loan now, at a time when asset prices are falling, could effectively help your family members buy more than what they could have before the bear market began. At the same time, it would reduce what you need to apply against your lifetime gift tax exemption.

Consult with a Financial Advisor Before Making a Loan

Because the tax implications of loans between family members can be tricky, you may find it helpful to consult with a fiduciary financial advisor or tax professional. The desire to help your family members is a natural one, and you should do it without hurting your own financial picture.

Financial Dynamics can help you assess whether making a low- or no-interest loan aligns with your personal financial goals and can incorporate the loan into your overall financial plan.

To discuss your personal situation with one of our financial advisors, contact our office to schedule a complimentary 30-minute phone call.


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