Many parents want to help their children buy a house or a car or meet some other need for cash. If so, a loan may be more practical than an outright gift. Moreover, if you make a formal loan to a child and collect a market rate of interest, you probably won’t incur tax problems.
Some parents, though, make interest-free or low-interest loans to their children. Such loans may have gift and income tax consequences. Under the tax code, foregone interest must be imputed on loans between family members, at the applicable federal rate (AFR).
Suppose, for example, Jane Brown loans $200,000 to her son Bill, payable in five years, with no interest due. Loans of three to nine years are considered “mid-term loans.” Suppose, at the time of the loan, the AFR mid-term rate published by the IRS was 4 percent
In this example, the imputed interest is $8,000 (4 percent of $200,000) per year. Each year, Jane must recognize $8,000 worth of taxable interest income. She also is deemed to have made an $8,000 gift to Bill, each year that Bill pays no interest.
Bill may get an $8,000 interest deduction each year. That would be the case if he could have deducted interest that actually was paid–for example, if he uses the $200,000 loan to buy a house.
