When it comes to financial support within families, deciding between giving a loan or a gift can be impactful due to the different tax implications of each. Well-off individuals often help family members with significant financial needs, like down payments or bridging tough times. The choice between a loan and a gift affects not just financial discipline but also potential family conflict, as loans come with the expectation of repayment, while gifts do not.
Gifts can be tax-free
Individuals can give gifts worth up to $16,000 per recipient annually, but more significant gifts must be reported to the IRS using Form 709. Still, more significant gifts can also be tax-free because the lifetime gift tax exemption is currently $12.06 million per individual. This exemption is through the Tax Cut and Jobs Act until the end of 2025, when it will decrease by half. Tax planning around this exemption is recommended, especially considering a future reduction.
Loans have more rules
Gifts are outright asset transfers with their own annual exclusions and lifetime exemptions. However, lending might be the better option if the giver expects repayment or has exceeded their lifetime gift exemption.
Family loans must adhere to IRS rules, including a written agreement, a fixed repayment schedule, and a minimum interest rate based on the Applicable Federal Rates (AFRs). Failure to charge this interest rate could result in taxation on the interest normally collected. Loans over $10,000 or those used to generate income also require reporting of interest income on taxes. Additionally, if a family member cannot repay a loan, and the lender wishes to claim a deduction for a bad loan, proof of an attempt to collect the funds is required. If the lender forgives the loan, the unpaid amount is considered a gift for tax purposes.
It’s important not to disguise a gift as a loan to avoid immediate taxation, especially with the current exemption limits. After 2026, when the exemption will decrease, this could become a more significant issue.
Intrafamily loans can benefit both parties, offering lower interest rates than commercial loans and saving the borrower interest over the life of the loan. For estate planning, an intentionally defective grantor trust (IDGT) can be used with a sizeable intrafamily loan, allowing the transfer of assets to a trust, either by gift or sale. This option can lower the taxable estate and avoid gift taxation for the beneficiary.
It depends on the family
Ultimately, the decision between a gift and a loan should consider family dynamics, the individuals involved, and the overall strategy for repayment. The giver or lender may view the money as an investment in the future, perhaps providing a solid financial foundation to a child with a young family by giving a substantial down payment for a home. The rationale could be providing financial support when they need it rather than waiting until probate when the child may have grown children of their own. There is no one correct answer, so it is essential to speak with an estate planning attorney who can ensure that the decision is compliant with all applicable laws surrounding family gifts and loans.