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In the discussion around this question about gift tax it was said that a loan must be at market rate, or it is not considered a loan.

Respecting the wisdom of the people who said that, I'm unclear about how this would work in the general case, since plenty of people do make interest free loans to family and friends, and the IRS would seem to be unlikely to be in the business of policing loan rates.

Ignoring the issue in the original question about later paying off the loan through a gift, let's say I make an interest free loan to someone, with the genuine intention that they pay it back in full at some later date, and with no intention of cheating the tax system. It would seem to me that he has no income to declare (because only the loan has occurred) and I have no income from the transaction. What exactly do he and I have to declare on our tax forms? Some links to tax office docs would be nice.

EDIT: Since it's been pointed out that it's hard to distinguish between loans and gifts, let's imagine that both parties have made a written loan agreement.

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  • Note that the fact pattern you described, from the perspective of the IRS, is hard to distinguish from a gift or a sale. They can't know if the loan will be repaid if you don't document it, and it doesn't look like a loan if you aren't charging for TMV. They also can't confirm that lender and borrower did not have a parallel transfer (maybe called "borrowing" to the taxman's face) of something valuable like a car or house. So you call it a loan, but the IRS can't tell it's not a gift or a sale. It's on you to prove it's a loan and not a gift.
    – NL7
    Commented May 5, 2014 at 18:07
  • You can have a bona fide debt without interest, in theory. So simply setting up a written loan agreement is a step in the right direction. But considering how easy it is to set up, why would you not do interest payments? To the extent the AFR imposes a low dollar amount, it's low-cost to set up interest payments. To the extent AFR imposes a high dollar amount, it's more important to establish the bona fides of the loan.
    – NL7
    Commented May 5, 2014 at 19:36

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In principle, the US taxes both income and gifts. Simply thinking good thoughts is not necessarily sufficient to avoid filing or payment obligations. Giving somebody money with no repayment date, no interest, and no enforceable note looks an awful lot like either income or a gift.

A loan normally has interest, money sitting in a savings account is insured, and other investments generally have an expected return. Why would somebody give a loan with no interest, with only flexible or informal payment expectations, in a way where it has neither deposit insurance nor any expectation of net returns? That looks a lot like a gift - at the very least, a gift of the time value and the default risk.

The IRS definitely polices loan rates. The latest release is Revenue Ruling 2014-13. The AFR is useful for tax concepts such as Original Issue Discount (when issuers sell low-interest or no-interest bonds or loans at less than face value, attempting to recharacterize interest income as return of principal), various grantor trusts (e.g. GRATs), and so forth. It's a simple way for the IRS to link to market rates of interest.

Documentation and sufficient interest, as well as clear payment schedule (and maybe call or demand rights) make it a bona fide loan. There is no real way for the IRS to distinguish between an informal arrangement and a post-hoc lie to conceal a gift. Moreover, an undocumented loan is generally difficult to enforce, so it looks less like a true loan.

The lender declares the interest payments as income on his Form 1040, line 8a and if necessary Schedule B.

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  • In this case the lender receives no interest payments, so the last line doesn't apply. Does the borrower have to declare anything? It's also not clear to me that the interest rates you link to are prescribed for all loans, rather than rates used for calculation purposes.
    – DJClayworth
    Commented May 5, 2014 at 18:56
  • Depending on the size of the loan, there may be imputed interest income. Smaller loans will often be exempted from this requirement, and some intermediate loans as well. But if you make a big loan, the IRS will impute interest to you (possibly then imputing it as either a gift or income to the person relieved of paying it). But if you don't establish interest payments, then it's generally presumed not to be a loan. For effective loan creation, the documentation should include sufficient interest and the reporting should include the interest.
    – NL7
    Commented May 5, 2014 at 19:17
  • You're looking for something clear and simple, but I don't think you'll find it. This is largely judge-led tax law, and the question of bona fide debt is not a direct one. The best practice is to make a clear document with a payment schedule that provides adequate interest. Although a bona fide loan may be found in court even without sufficient interest, that's not going to reliably apply in cases such as the one you've described and most tax advisors will urge against it. You've constructed something that to an agent will look like a simple gift with a worthless promise on top.
    – NL7
    Commented May 5, 2014 at 19:30
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I am neither a lawyer nor a tax accountant, and if you're dealing with serious money I suggest you consult a professional.

But my understanding is: If you make a loan at zero interest or at below-market rates, the IRS will consider the difference between the interest that you do charge and the market rate to be a gift. That is, if someone could get a loan from a bank and he'd pay $1000 in interest for the year, but instead you loan him the money as a friend interest free, than as far as the IRS is concerned you have given him a $1000 gift, and you could potentially have to pay gift tax. Or they might "impute" the interest to you and tax you on $1000 of additional income.

If you have no agreement on repayment terms, if it's all, "Hey Joe, just pay me back when you can", then the IRS is likely to consider the entire "loan" to be a gift.

There's an annual exclusion on gifts -- I think it's now $13,000 -- so if you loan your buddy fifty bucks to tide him over until next pay day, the IRS isn't going to get involved in that. They're worried about more serious money.

And yes, the IRS does "police loan rates". The IRS examines exact numbers for all sorts of things. If, say, you go on a 100-mile overnight business trip, and the company gives you $10,000 for travel expenses, the IRS is likely to say that this is not a tax-deductible travel expense at all but a sham to hide part of your salary from taxes. Or if you donate a pair of old socks to charity and declare a $500 charitable contribution deduction, the IRS will say that that is not a realistic value for a pair of old socks and disallow the deduction. Etc. A small discrepancy from market rates can be justified for any number of reasons. If the book value of a used car is $5000 and you sell it to your neighbor for $4900, the IRS is unlikely to question it, there are any number of legitimate business reasons why you had to give a discount to make the sale. But if you sell it to him for $50, they may declare that this is not a sale but a gift. Etc.

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    I think exclusion may now be $14k.
    – NL7
    Commented May 7, 2014 at 1:21
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    If you websearch "family loan", you will find several legal firms that specialize in setting these up so they'll pass muster with the IRS and -- if disaster occurs and it becomes necessary -- be legally enforcable, The one I used had some good resources explaining what the trade-offs were, and suggesting that -- as @Jay suggests -- the best solution is to charge something close to the IRS's minimum rate, then gift the payments (or the interest) until the loan can be paid back. ...
    – keshlam
    Commented Aug 30, 2014 at 16:54
  • ... You will have to declare the paid interest as income even if you're gifting them, but since the mandated rate can be very low the tax impact on you is relatively small. Note that to make sure all the tax laws, state and federal, are covered you may need to officially register the loan, which is what those firms specialize in. It cost us about $700 to have them draw up, and file, appropriate paper to document a $300,000 loan; that's cheaper than a local tax lawyer would have charged.
    – keshlam
    Commented Aug 30, 2014 at 16:59

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