Updated for tax year 2023.
As a parent, there’s a chance you may lend your kids money throughout life. Maybe it’s to buy a bicycle, to get their first car, or even to purchase their very own home. But, when you fork over cash to your family, does the Internal Revenue Service (IRS) care about those loans?
At a glance:
- Small loans to your children are not a concern for the IRS.
- Charge interest on significant loans toavoid gift taximplications.
- If your child doesn’t pay back the loan, you can take a bad debt deduction.
Does the IRS care if I loan money to my kids?
For small loans under $10,000, the answer is simple — no. The IRS isn’t concerned with most personal loans to your son, daughter, stepchild, or other immediate family member. They also don’t care how often loans are handed out, whether interest is charged, or if you get paid back.
But, as with most things, there are exceptions.
Interest-free loans
If you loan a significant amount of money to your kids — over $10,000 — you should consider charging interest.
If you don’t, the IRS can say the interest you should have charged was a gift. In that case, the interest money goes toward your annual gift-giving limit of $17,000 per individual (as of tax year 2023). If you give more than $17,000 to one individual, even if the individual is your child, you are required to file agift tax form.
The rate of interest on the loan must be based on the lesser ofapplicable federal rates (AFRs) set by the IRS or the borrower’s net investment income for the year. You don’t need to charge interest if the borrower’s investment income is $1,000 or less. If you choose to charge interest lower than the AFR, it’s called a below-market loan, and there are tax implications. See the last section in this article for more information about this topic and some exceptions.
Family loans that are really gifts
Some people may think they can give large amounts of money to their children and call it a loan to avoid the hassle of filing a gift tax return, but the IRS is wise to that. The loan must be legal and enforceable. Otherwise, it may be deemed a gift.
When loaning money to a family member, it’s good practice to seek legal counsel and have a professional help you draw up an official loan agreement for both parties to sign.
Student loans for tuition
You can give “student loans” to help fund your kid’s higher education by drawing up a contract like any other loan.
When they graduate and start making payments, your children can take thestudent loaninterest deduction on any interest paid to you. Remember that you will have to pay taxes to the IRS on that interest income.
Take a bad debt deduction if your child doesn’t pay you back
One of the advantages of a loan contract is that if your child doesn’t pay, you can take a deduction for anon-business bad debt. Additionally, you don’t have to pay gift tax to the IRS on the amount you would have if you had gifted the money.
To take a bad debt deduction, you must prove that the debt is truly worthless and there is no chance you will be paid back. Have your child make a written statement that they cannot pay, and gather as much evidence that you tried to collect the debt as possible. Letters, invoices, and phone calls can all be used as proof in this instance.
Filing a gift tax return for a loan
But what if you fail to document the loan properly and legally, and the IRS decides your loan is actually a gift?
In most cases, you won’t have to pay taxes for a “loan” the IRS deemed a gift. Even if you exceed the $17,000 annual gift exclusion we mentioned before, you onlyowe gift taxwhen your lifetime gifts to all individuals exceed the lifetime gift tax exclusion. For tax year 2023, that limit is $12.92 million (up from $12.06 million in 2022).
If you’re like most people, that means you’re probably safe, but you still need to keep track of and report any gifts that exceed the annual exclusion ($17,000 in 2023).
Other family loans that are safe from tax consequences
You don’t have to worry about family loans being subject to tax consequences if:
- You lend a child $10,000 or less, and the child does not use the money for investments, such as stocks or bonds.
- You lend a child $100,000 or less, and the child’s net investment income is not more than $1,000 for the year.
If you don’t fall within the above exceptions, it might be a good idea to read up on below-market loans in IRS Publication 550 to determine the tax implication.
Considering the financial implications of lending significant amounts to family members, it’s prudent to use a Tax Calculator, such as TaxAct’s, to assess potential tax consequences. For loans exceeding $10,000, where charging interest is recommended to avoid gift tax implications, a Tax Calculator can help determine the appropriate interest rate based on applicable federal rates (AFRs).
It provides a practical tool to navigate complex tax scenarios, ensuring compliance with IRS regulations. Additionally, when creating loan agreements or assessing the need for a bad debt deduction, a Tax Calculator can offer insights into optimizing financial decisions and understanding the potential impact on taxes. Utilizing such a tool adds a layer of financial precision, helping individuals make informed choices and maintain clarity on their tax obligations.
