First, let’s rephrase the question, “Why might I loan money to my children rather than make it a gift?”
The tax code establishes a maximum annual gift limit. It is called the “annual gift tax exclusion.” As of this writing the annual gift tax exclusion is $16,000. Any amount gifted over the annual gift tax exclusion that is not subsequently earmarked as part of a lifetime gift tax exemption triggers a tax payable by the person making the gift.
If my spouse and I wanted to give our child $160,000 to help buy a house, we have two choices. We can gift the entire amount and pay gift taxes, or, extend a $160,000 loan, pay no gift tax and reduce the principal each year by the annual maximum gift tax exemption.
This is a great way to help family members with large purchases. They will need to provide interest repayment on a regular basis. The loan, any annual gift tax exclusions applied to the principle on the loan and the interest payments on the loan are traceable in the ZimpleMoney system
Here’s how it works using the above example:
- Two parents offer a $160,000 loan that is effectively an “interest only” loan to help buy a house.
- In year one, one parent gifts $16,000 to the child and uses the gift to reduce the principal on the loan by the same amount. The other parent does the same since they can both gift $16K. So the total reduction of the principal on the loan in year one is $32K, leaving $128K in principal on the loan after the first year.
- During that year, the child only pays interest on the loan, and all interest they pay is tax deductible
If both parents continue to gift the maximum annual gift tax exclusion every year and apply that gift to the loan, the loan will be paid within 5 years and the only fees the borrower (their child) will incur are interest on the remaining balance.
But that’s not all. As a real bonus, if Grandma and Grandpa and or Aunts and Uncles also pitch in, the kids can receive $16,000 from each family member annually for each child. Mom & Dad + Grandma & Grandpa + Aunt & Uncle = up to $96,000 in one year. All traceable via ZimpleMoney.
The kids can pay interest payments monthly or annually and if they are working, these payments will be deducted from their income tax liability each year. It’s a win/win scenario for both the parents (and other family members) and children.
Properly documenting a loan and collecting regular payments from the borrower demonstrate that a loan is a loan and not a gift. The IRS can deem a loan to be a gift if it’s not properly documented or if payments are not made at least annually, potentially subjecting the lender and borrower to unanticipated tax liabilities. We highly recommend that you discuss your individual situation with your CPA or attorney.