Lending to Friends and Family

The first thing which may come to mind when lending money to friends or family may be thoughts around impact on your relationship, because this is just a personal matter, right? Well, the Internal Revenue Service may feel differently.

There are some things which you should keep in mind, and some things you should absolutely do when providing family/friend loans. While it may seem less than friendly, consider charging interest. The IRS wants to be able to calculate gift taxes against the amount you would ultimately owe in estate taxes when you pass on assets to your heirs. If you were to make a no-interest loan to a son or daughter, the IRS would count the amount of interest you would be foregoing as a gift. If you do charge interest, the amount of interest would need to be reasonable in the eyes of the government.

Essentially, if you charge family members or heirs less than the minimum Applicable Federal Rate (AFR), then the government would calculate the difference – which would be counted as a gift to the family member to whom you made the loan. The government determines this rate by monitoring interest rate movements in the marketplace and calculating the minimum AFR for loans covering different time periods, then posting them on its website. If you charge family members or heirs less than this rate, then the government would calculate the difference, and that would be counted as a gift to the family member to whom you made the loan.

These rates are fairly low. For example, a short-term AFR (up to 3 years) in September 2021 was 0.17%; the AFR on loans of 3-9 years is 0.86%, and anything over 9 years would have a rate of 1.71% to 1.73%, depending on whether the interest is being paid back yearly, quarterly or monthly.

Note that these rules don’t apply to loans of less than $10,000 which are not used to purchase income-producing property. If you don’t want to go through the hassle of charging interest, you could always calculate (or have a professional calculate) the implied interest payments, and then offset that amount with your $15,000 annual gift exemption to the borrower. But even then, it’s a good idea to document the terms and stated interest rate in case the IRS ever decides to come back and do an audit.