Loans and Sales to Children
One of the considerations for parents who make a loan is whether they are treating all children fairly. Most parents hope to treat their children equally. But the need for a loan will probably exist with one child and not with the others.
As a result, parents may consider making the loan to a child and then planning to forgive that loan in the estate plan. If this is the case, a parent may create a similar benefit for other children in the estate plan. By forgiving the loan to one child and passing a similar benefit through the estate to the other children, everyone is treated fairly.
Family Loan Guidelines
An "oral agreement" family loan may cause serious conflict. Parents or children may forget the loan amount, the loan duration and the interest rate. Therefore, the loan document should be written.
It frequently is either a "demand" note or a term note. A term note is for a fixed number of years, in a manner similar to most notes for the mortgage on a home. A demand note allows the parent to request full payment at any time. Many family loans are made on demand notes and there may not be an expectation that the principal will be repaid.
Will There Be Taxes?
If the demand note does not require any interest or specifies an interest rate that is below the market rate, then there is assumed income to the parent. In effect, the child is treated as if he or she is making payments of the interest to the parent at the appropriate rate. Even though no interest may be paid, the parent will be required to report income in that amount. If the loan interest is deductible by the child, he or she may take that deduction.
With a no-interest demand note, the parent also is making a gift. However, the annual exclusion ($17,000 in 2023) is frequently sufficient to cover the gift of the parent in forgiving interest payments by the child. If there are two parents, the gift exclusion amount is doubled.
In many cases the note will be written at the applicable federal rate for the month it is created. The IRS publishes a revenue ruling each month with applicable rates for loans of various duration. So long as the note bears an interest rate at that rate, there will not be a gift.
It is beneficial if the child actually makes payments to the parent at the applicable interest rate each year. Even if the parent has used annual gift exclusions to provide funds to the child, a written note with payments by the child shows that the parents and child are treating the note in an appropriate businesslike manner. This makes it much more difficult for the IRS to claim that the principal value of the note was an immediate gift to the child.
Family Loan Exceptions
There are two general family loan exceptions. First, a loan of $10,000 or less is not covered by the "market interest rate" rules. A parent may make an interest-free loan of that amount without any impact.
Second, if the loan is from a parent to a child and is $100,000 or less, there may be another exception that reduces the amount of the assumed income interest reported by the parent. For these loans, the parent may report income that is the lower of the applicable federal rate or the child's actual net investment income for the year. This may reduce the income reported by the parent.
Mother Carol Helps Daughter Susan Purchase a Home
Mother Carol wanted to help daughter Susan purchase a home. Mother Carol lent Susan $100,000 on a written demand note. The applicable federal interest rate that month was 3.2%. Susan does not pay interest on the note and therefore Carol has assumed income. Her income each year is 3.2% or $3,200. In addition, Carol is making a gift of $3,200 to Susan each year. Fortunately, there is no gift tax because it is less than the annual gift exclusion amount.
If Susan records the $100,000 loan as a second mortgage against the home that she purchases, she will be able to deduct the $3,200 of income that Carol reports. However, because Susan is likely to be in a lower tax bracket, Carol will still pay a substantial tax that is likely to exceed Susan's tax savings.
Bill Helps Son Joe Start a Business
Bill would like to assist his son Joe who is starting a business. Bill lends Joe $50,000 on a demand note. The note requires an annual payment of 3.2%, which is the applicable federal rate on the date the note is created. Under the note terms, Joe must pay $1,600 of interest to Bill at the end of each year.
Joe starts the business and makes the payment of $1,600 each year to Bill. Joe's CPA deducts the payment on Joe's tax return as an ordinary and necessary expense of the business.
There are a number of circumstances in which a parent may wish to sell real estate or stock in a family business to a child.
Many parents also choose to make gifts of land or stock to children. However, a parent may have already used the annual exclusion and his or her gift exemption. Alternatively, the parent may desire the economic security of payments on the property. Some parents prefer to sell assets to children and then have the payments available for retirement income.
Finally, a parent may give part of the land or stock to a child and then sell the balance. This transfer enables the child to own the investment or business. However, the child benefits from the self-worth that results from the process of making payments on the note. While the child has been given part of the property or business, he or she has the self confidence that comes with making the business productive and paying on the note.
Because children who purchase assets are frequently in the initial years of their careers, they usually lack the funds to purchase the entire property or stock in the business. As a result, it is quite common to use an installment sale.
From the perspective of a parent, the installment sale also has the benefit of spreading out the capital gain. He or she probably has a high level of appreciation in the land or stock. Using an installment sale will allow that gain to be recognized over a term of many years. Because the tax on the gain is not due until each portion is recognized, the total cost of the capital gains tax may be significantly reduced. If the real property includes depreciated buildings, the installment sale may not be available.
The parents also may be thinking of the impact on their estate plan. It may be quite desirable to "freeze" the value of a particular asset through an installment note. If the parents owned a parcel of land until they pass away, that property could greatly increase in value by the time of their death. However, if they freeze the value by selling it at a fair price on an installment note, then the growth in value of the land will benefit the children's estates.
Installment Sale Taxation
The primary benefit of an installment sale to the parent is that the capital gain is prorated. The CPA for the parent will develop a schedule showing the amount of the interest (which is ordinary income to the parent) and the amount of the capital gain each year. The payments by the children will be in part ordinary income on the interest portion and capital gain on that portion for the parent each year. If the parent has a tax basis in the property, a portion of each payment will be returned with no tax.
There is an important limitation on the installment sale to the child. If the parent transfers the property to the child, the child should not sell within two years. If the child were to sell the property prior to the two year limit, then in most cases the gain will immediately be taxed to the parent. Therefore, if a parent sells assets to a child on an installment note, the child should plan to hold the property for a minimum of two years.
Joe and Mary Sell to Daughter Linda
Joe and Mary have a commercial lot that is valued at $200,000. The adjusted basis is $20,000. They would like to sell this lot to their daughter Linda. She will make payments to Joe and Mary.
Because the applicable federal rate is 3%, Joe and Mary set up a 20-year installment sale to Linda using the 3% interest rate.
Each year, Linda will make a payment of the interest plus principal as set forth in the note that has been developed by the family's CPA. Joe and Mary will report the interest as ordinary income and a portion of the capital gain. Their prorated part of the $20,000 of basis is tax free. Because Linda plans to hold the lot and will not sell within two years, there will be no acceleration of the capital gain for Joe and Mary.
Joe and Mary also considered other options with their CPA. One possibility is for there to be a provision in the 20-year note that would eliminate the debt if both Mary and Joe pass away prior to the end of 20 years. This provision to cancel the debt if the parents die early is called a "self-canceling installment note."
Another option is to use an alternative to the installment note called a private annuity. With the private annuity, Joe and Mary would receive payments from Linda for their lifetimes, rather than the fixed term of the installment note.
After discussing these two other concepts with their CPA, Joe and Mary decided to use the 20-year installment note. This will freeze the value and gives Linda a clear picture of the payment amounts and schedule.