Want to loan a family member money informally without interest? Think again.
Texas residents are subject to Federal law on the lending of money to family members. We often find our Texas clients want things to be handled casually when loaning money to family. Unfortunately, casually loaning money can have unintended consequences that leave you vulnerable to problems with the IRS or enforcing repayment of the loan. Under governing Federal law, a valid and enforceable loan agreement requires a minimum of three things.
First, the person borrowing money must be required unconditionally to repay the funds they borrow. This means you need to set out basic terms in a Texas loan agreement such as the amount of the principal payments due, the date the payments are due, the duration of the loan, security requirements when applicable (i.e., the collateral for the loan), the terms of default, and language to deal with how you will handle prepayment of the loan.
Second, as the lender, you must have every intention for your family member to repay the loan. You cannot preplan to forgive the loan, or you could unintentionally invalidate the loan because your underlying plan is to forgive the debt and essentially gift the loan proceeds. In 2020-2021, you can gift up to $15,000.00 to an individual or $30,000.00 to a couple under the annual federal gift tax exclusion. Anything above this annual federal gift tax exclusion will require you to file IRS Form 709 commonly referred to as the gift tax return. Filing a gift tax return does not mean you owe taxes on that money right now, but it does mean that the funds you gift will go toward your lifetime gift and estate tax exemption. In 2021, the lifetime gift and estate tax exemption limits are $11.7 million for an individual and $23.4 million for a couple. However, it is important to notate that the lifetime gift and estate tax exemption increased under the Tax Cuts and Jobs Act (the “TCJA”), which went into effect in January 2018, is set to expire at the end of 2025. Unless the TCJA is extended by Congress, the prior exemption of $5.49 million, adjusted for inflation to approximately $6.4 million per person, will go back into effect on January 1, 2026. The good news is that under IR-2019-189 issued on November 22, 2019, the IRS confirmed they will not claw back any gifts made under the TCJA increased gift tax exemption limits when those limits are reduced in the future.
Lastly, you must include interest on the loan. Texas clients often do not want to include interest to family members, but the unintended consequence of not doing so is that your loan is unlawful and likely unenforceable. The good news is that the interest rate does not need to be what you would normally obtain from a commercial lender. Texas residents who make intrafamily loans are permitted to lend money using the Applicable Federal Rate (“AFR”). The AFR is broken down into three categories: (1) short-term loans up to a term of three years; (2) mid-term loans ranging from a term of three years to nine years; and (3) long terms loans with terms longer than nine years. The IRS publishes the AFR monthly, which you can obtain by visiting FederalRates.Gov. You also need to report the interest you receive on the loan to the IRS on a Form 1099-INT and your tax return. Depending on the type of loan, you may also need to report interest to the IRS on a Form 1098.
If you need help with drafting a loan agreement between family members or are concerned about the possible reduction or reversion of the lifetime gift and estate tax exemption, please contact the real estate and estate planning attorneys with ML|MW in Houston and Sugar Land. We can help you draft loan agreements that protect you as well as your family and implement an effective strategy to maximize gifting under the current TCJA exemption limits.