Tax benefits of below-market loans to children.

• Author: Ellentuck, Albert B.

Interest-free or low-interest loans were once a popular and successful means of shifting income from parents to children. The beneficial tax treatment of such loans has been reduced by Sec. 7872, which requires the parties to impute interest income and expense on below-market-rate loans and treat the imputed interest as a gift. However, opportunities still exist for families to use intrafamily loans to reduce taxes and improve the economics of certain situations. The discussion below is limited to interest-free or below-market-rate gift loans to children.

Definition

A "gift loan" is a below-market loan in which the forgone interest is in the nature of a gift. The lender-parent is deemed to have made a loan to the borrower-child at the applicable Federal rate (AFR). At the end of the calendar year, the parent is deemed to have made a gift to the child of the interest; the child is deemed to have paid the parent the interest. The parent must recognize interest income as if the imputed interest had actually been paid. The child may be entitled to an interest deduction in the same amount, subject to the Sec. 163 interest expense rules.

Loan types: Gift loans can be either of the following types:

1. Demand loan. This kind of loan is payable in full, at any time, on the lender's demand. If interest on a demand loan is payable at a rate less than the AFR established monthly by the IRS, the demand loan is a below-market loan to which the Sec. 7872 imputed interest rules apply.

2. Term loan. This is any loan not a demand loan. Thus, if a loan has a specified period in which it will be outstanding, it is a term loan. If the amount loaned exceeds the present value of principal and interest due under the loan using a discount rate equal to the AFR in effect when the loan is made, the term loan is a below-market loan to which the Sec. 7872 imputed interest rules apply.

Exceptions to the Imputed Interest Rules

$10,000 exception: If the total outstanding loans to a child do not exceed $10,000, the imputed interest rules generally do not apply. However, according to Sec. 7872(c)(2), if a loan is directly attributable to the purchase or carrying of income-producing assets, the rules do apply. This means the money must be spent and not placed, for example, in a savings account, if the rules are to be avoided. The $10,000 exception applies only to gift loans between individuals; a gift loan involving a trust would not be eligible for the exception.

$100,000...