Q: My parents would like to give me a loan of $150k. How can we structure this loan so that we are in compliance with any rules from the IRS?
A: To structure a loan in compliance with the IRS rules, you need to take the following steps:
• Prepare a written loan document. It’s best to have one drafted by a lawyer but in a pinch, you can create one from various websites that feature legal document templates.
• Include a stated interest rate with the rate being no lower than the IRS published Applicable Federal Rate (AFR) listed at: https://apps.irs.gov/app/picklist/list/federal-Rates.html.
• Also include an amortization schedule showing the dates that payments are due and reflecting the interest that will be accruing and due with each payment. Bankrate.com has a great online loan amortization tool.
• Stick to the payment schedule.
One strategy is for your parents to forgive the interest that you need to pay each year by making a Gift to you. In that case, the person lending the money won’t pick up the interest earned on their tax returns as income. And the borrower won’t deduct the interest paid.
A portion of the loan balance can be Gifted too. The total amount of the interest and principal that can be Gifted each year is limited to the $15k per person per year Gift limit. That means your parents can Gift you and your spouse $60k per year, assuming they are both still living and married. The amount that can go towards the principal and interest would be $60k less any other gifts made to you during the year. (Gifts in excess of the $15k per person per year need to be reported on a Form 709 Gift Tax return and reduce the total wealth a person can shield from Estate Taxes when they die.)
On the other hand, if you use the money to purchase or improve your primary residence or second home, or to refinance an existing mortgage, you can deduct the interest paid during the year that does not exceed a total of $750k of mortgage debt (or up to $1 million if refinancing a mortgage in existence prior to 12/2017). To claim the mortgage interest deduction you would need a lawyer to record this loan at your state’s Registry of Deeds as a mortgage and attach it to your deed.
Interest rates are still quite low. And your parents or other relatives might be looking to get a little higher interest rate on a portion of their savings than they can currently earn on bank CDs and Money Market accounts. In situations like that, a family loan might end up being a Win-Win for both parties involved.
Is A Gift of Money Reportable?
The general rule is that any gift is reportable but there are exceptions. The following gifts are usually NOT:
• Gifts that are not more than the annual exclusion for the calendar year (currently $15,000).
• Tuition or medical expenses you pay for someone (the educational and medical exclusions).
• Gifts to your spouse.