Tax benefits of below-market loans to children.

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 exception: A second exception allows loans of up to $100,000 to escape the roles if the child's net investment income does not exceed $1,000. If it does exceed $1,000, Sec. 7872(d)(1) limits the interest imputed to the child's net investment income. "Net investment income" is the excess of investment income over investment expenses, as provided in Sec. 163(d)(4). However, this limit affects only the income tax treatment of the deemed interest income; gift tax consequences still apply to the forgone interest.

Observations: Neither of these exceptions applies if the loan's purpose is tax avoidance. While the $10,000 exception addresses how the specific funds are spent, the $100,000 exception deals with how much investment income the child has.

Examples

Adam makes an interest-free loan of $10,000 to his son, Ben, who has $1,500 net investment income. Ben uses the money to pay college tuition. The loan is under the $10,000 de minimis exception, so the imputed interest rules do not apply, unless the IRS determines that the purpose of the loan was tax avoidance. If Ben placed the $10,000 in a savings account, interest would have to be imputed.

Charlotte makes a $100,000 interest-flee loan to her daughter, Doris, who has no investment income. Doris uses the money to buy investment real estate (not an income-producing asset). The loan is under the $100,000 exception and, because Doris has no investment income, the imputed interest rules do not apply. If Doris had $2,000 investment income, imputed interest would be computed, but would be limited to her $2,000 net investment income. In either case, the loan would enable Doris to benefit from any appreciation on the property, with little or no additional cost to Charlotte.

Caution: Under Secs. 1(h)(11)(D) and 163(d)(4)(B), taxpayers can elect to include net capital gains and qualified dividend income in investment income when computing deductible investment interest expense. However, borrowers of below-market loans should use caution in making these elections, because they could adversely affect the interest required to be imputed on the below-market loan.

Editor's note: This case study has been adapted from Guide to Tax Planning for High Income Individuals, 5th Edition, by Anthony J. DeChellis, Douglas L. Weinbrenner, Catherine A. Roeder and Patrick L. Young, published by Practitioners Publishing Company, Ft. Worth, TX, 2004 ([phone]; ppc.thomson.com).

Albert B. Ellentuck, Esq.

Of Counsel

King & Nordlinger, L.L.P

Arlington, VA