A client reached out this week to discuss ways she could best help a family member financially. She was curious what the implications were if she gifted the funds versus setting up a loan. I thought it was a great topic to share more broadly, so let’s dive in.
Start with your intentions
Before you evaluate your options based on the financial and tax dynamics (ie: gifting and lending), take a minute to assess the transfer more qualitatively. It’s very important to consider the underlying tenor of the financial assistance being offered to a family member. Evaluate how you want the money transfer to be viewed by both parties. If money is transferred as a gift, it is reasonable to assume that you do not expect future repayment and do not intend to earn any interest. You are simply giving them funds to make their life easier right now and don’t expect (or want) anything in return.
However, if they are just in a tough spot right now and fully intend (and want) to pay you back in time (and if you agree with this fact pattern), then a loan is the better option. Family dynamics can be tricky, so be sure to spend the time looking at the more qualitative aspects of both options – in addition to the “rules” for each outlined below.
As noted above, consider this option if you wish to give a gift – with no expectation of anything in return (including repayment).
We’ve written about this topic in depth in the past (read post here). To quickly summarize, each year, gifts under the annual exemption limit (set by the IRS, currently $17,000 per recipient for 2023) can be made without any issue or tax filings. Any gift over that amount must be reported on a gift tax return. The amount above the annual exemption will be tracked against your lifetime gift exemption (which is the total you can give away tax-free during your life).
The current lifetime gift exemption is $12.92 million per individual (U.S. residents only). This amount is indexed for inflation through December 31, 2025, when it would decrease by 50% under current law.
If your wish is to help a family member out now – but ultimately get repaid – a loan is a better choice. If you go this route, be sure to adhere to the rules regarding such loans set by the IRS (designed to prevent preferential terms between family members.)
The IRS mandates that any loan between family members be made with a signed written agreement, a fixed repayment schedule, and a minimum interest rate. The agreement should lay out all the terms and be kept on file by both parties to the loan.
The minimum interest rate is also dictated by the IRS (they publish Applicable Federal Rates monthly). You want to ensure you are in compliance with these rates as there are steep penalties for charging too low of a rate. (The IRS could tax you on the interest you could’ve collected but didn’t. What’s more, if the loan exceeds $10,000 or the recipient of the loan uses the money to produce income (such as using it to invest in stocks or bonds), you’ll need to report the interest income on your taxes.)
When the loan is in place, you will need to report the interest income you earn (which you can calculate using an amortization schedule based on the loan terms) in your tax return each year.
Money can be complicated. And so can family dynamics! It’s a best practice to level set expectations on the front end between all parties and carefully apply the related tax rules for the option chosen.
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