Parents’ interest-free loan prompts question “Albuquerque Journal
Q: My husband and I bought our first home last year and my parents loaned us $ 44,000 so we could get a better mortgage deal. We’re making monthly payments on this loan, but my dad told us he wouldn’t charge us interest. After a discussion with a tax preparer, I am concerned that there are additional tax returns that we will need to do for this loan. I was told it is because the loan is below the market due to lack of interest. The preparer asked me to provide the loan details when we bring our information for the 2020 tax return. Before I do that, I want to get an idea of what the effect will be on us. Can you summarize for us what we might have to report?
A: Let me start by saying that at the end of the day there’s a good chance you won’t need to report anything. But it’s important that you understand why so that you can discuss the issue with the preparer if you hear a different answer.
The tax law has rules for below market loans, which means a loan with a lower interest rate than a rate released each month by the IRS. This target rate is a “risk-free” rate determined by what US Treasury securities of similar duration pay.
To illustrate, suppose the target rate is 2%. The law generally requires that the loan call for at least this 2% interest, or that the lender and borrower be required to act as if 2% were charged (again, this is just an example of rate).
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The end result is to assume that the loan calls for the required rate, and then to assume that the lender, who provided a benefit by not charging that interest, pays the borrower the interest. Since the borrower doesn’t actually get it, or the lender gives it away, then the law assumes that the borrower is paying the interest back to the lender.
In your case, if the transfers take place every year and I use $ 44,000 as the outstanding balance for the entire year, we assume that your parents give you $ 880 (2% of $ 44,000) as a gift and you Then return them $ 880 in interest payment.
So what is done is to measure the benefit you receive by not paying “fair” interest and then ask if the lender actually gave you the benefit of $ 880 which you then returned as payment. of interest.
Two things would happen for tax reporting purposes. First, your parents should act like they gave you and your husband a gift of $ 880. Second, you could act like you’re paying $ 880 in interest, but your parents should act like they’re receiving $ 880 in interest.
At this point, everyone understands what the tax result is. Let’s start with the gift. Gifts are not income for the recipient, so you don’t report. Gifts may need to be reported to the IRS, but only if they exceed $ 15,000 per person each year.
If your parents have not made any other donations which, together with the $ 440 to you and the $ 440 to your husband, would exceed $ 15,000 to each of you, there is no declaration of this deemed donation. $ 880 ($ 440 each).
Interest can be another story. But the law has a special exception that may apply. If the total below market loans do not exceed $ 100,000 for the year, this interest transfer cannot exceed the net investment income you report on your tax return. If your investment income is $ 1,000 or less, you can simply skip this step.
Investment income includes interest and certain dividends and capital gains, but not “qualified” dividends or long-term capital gains. The end result might just be that you can ignore this report of interest. If so, your parents don’t report interest income either.
If interest must be declared because your investment income is too high, you can only deduct interest deemed paid if your parents registered a mortgage to top up a guaranteed interest on your home.
Jim Hamill is the Director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at [email protected]