Update 2014-03-08: Estate Planning Issues With Intra-Family Loans and Notes by Steve R. Akers, Bessemer Trust, August 2012 has examples, advantages/disadvantages of loans vs gifts, and applicable legal precedent.

Quote from the article regarding problems with loans

Avoiding Non-Performance Complications. If the borrower does not make payments as they are due, additional complications arise. Possible Recharacterization as Gift. As discussed in the next Item, the IRS takes the position that if the “lender” intended to forgive the note from the outset, the transfer is a gift. ... questions can arise, possibly giving rise to past due gift tax liability which could include interest and penalties. Imputed Gift and Interest Income. Even if the loan is not treated as a gift from the outset, forgiven interest may be treated the same as forgone interest in a below-market loan, resulting in an imputed gift to the borrower and imputed interest income to the lender. ... Modifications Resulting in Additional Loans. If the parties agree to a loan modification, such as adding unpaid interest to the principal of the loan, the modification itself is treated as a new loan, subject to the AFRs in effect when the loan is made, thus '''further compounding the complexity of record keeping and reporting.'''

The article continues with relevant cases and revenue rulings (specifically Revenue Ruling 77-299). The conclusion of the cases/revenue ruling section points out several good items to consider.

The better approach seems to be that, even if there is an intent to forgive the note payments from the outset, the transfer should not be treated as a gift initially. (1) The donor is free to change his mind at any time, (2) his interest in the note can be seized by a creditor or bankruptcy trustee, who will surely enforce it, and (3) if the lender dies, his executor will be under a duty to collect the note.

Properly documenting, structuring, and administering a loan is important to avoid treatment as a gift. This includes:

  • A signed promissory note with a fixed repayment schedule with an interest rate at or above the AFR
  • Secure or collateralize the debt
  • Demand repayment
  • Maintain records

Problem with loans that are payable on demand: Dickman v. Commissioner held that interest-free loans between family members are gifts for federal gift tax purposes.

This is a great article that goes on to cover many additional issues and scenarios.

Overview article from Smart Money (last updated 12-13-2007) Loans Among Family Members. Although an interesting summary, the article doesn't mention the applicable Internal Revenue Code - so follow-up to specifics is impossible without more research.

IRC section 7872 contains the additional information needed to examine the issues and exceptions of loans to family members.

Applicable Federal Rates:

Other possibly relevant documents

  • Family Budget Spreadsheet - use a zero based approach to determine how income covers necessities first and then trickles down and stops at optional spending.
  • IRS Pub 550 - pg 6 & 7
    • see also Ch 3 for calculation notes on Net Investment Income, pg 32 -
    • Net investment income generally includes interest, dividends, annuities, and royalties. It does NOT include qualified dividends or net capital gain.
  • Form 4952, Investment Interest Expense Deduction for calculating Net Investment Income
                     TITLE 26--INTERNAL REVENUE CODE

                Subtitle F--Procedure and Administration

                        CHAPTER 80--GENERAL RULES

        Subchapter C--Provisions Affecting More Than One Subtitle

Sec. 7872. Treatment of loans with below-market interest rates

(a) Treatment of gift loans and demand loans

                           (1) In general

        For purposes of this title, in the case of any below-market loan 
    to which this section applies and which is a gift loan or a demand 
    loan, the forgone interest shall be treated as--
            (A) transferred from the lender to the borrower, and
            (B) retransferred by the borrower to the lender as interest.

                    (2) Time when transfers made

        Except as otherwise provided in regulations prescribed by the 
    Secretary, any forgone interest attributable to periods during any 
    calendar year shall be treated as transferred (and retransferred) 
    under paragraph (1) on the last day of such calendar year.

--- skip

(c) Below-market loans to which section applies

      (2) $10,000 de minimis exception for gift loans between 

        (A) In general

            In the case of any gift loan directly between individuals, 
        this section shall not apply to any day on which the aggregate 
        outstanding amount of loans between such individuals does not 
        exceed $10,000.

--- skip

(d) Special rules for gift loans

     (1) Limitation on interest accrual for purposes of income 
                  taxes where loans do not exceed $100,000

        (A) In general

            For purposes of subtitle A, in the case of a gift loan 
        directly between individuals, the amount treated as 
        retransferred by the borrower to the lender as of the close of 
        any year shall not exceed the borrower's net investment income 
        for such year.

--- skip

        (E) Net investment income

            For purposes of this paragraph--
            (i) In general

                The term net investment income has the meaning given 
            such term by section 163(d)(4).

            (ii) De minimis rule

                If the net investment income of any borrower for any 
            year does not exceed $1,000, the net investment income of 
            such borrower for such year shall be treated as zero.

--- skip

(f) Other definitions and special rules


                     (2) Applicable Federal rate


        (B) Demand loans

            In the case of a demand loan, the applicable Federal rate 
        shall be the Federal short-term rate in effect under section 
        1274(d) for the period for which the amount of forgone interest 
        is being determined, compounded semiannually.

                            (3) Gift loan

        The term ``gift loan'' means any below-market loan where the 
    forgoing of interest is in the nature of a gift.

                          (4) Amount loaned

        The term ``amount loaned'' means the amount received by the 

                           (5) Demand loan

        The term ``demand loan'' means any loan which is payable in full 
    at any time on the demand of the lender. Such term also includes 
    (for purposes other than determining the applicable Federal rate 
    under paragraph (2)) any loan if the benefits of the interest 
    arrangements of such loan are not transferable and are conditioned 
    on the future performance of substantial services by an individual. 
    To the extent provided in regulations, such term also includes any 
    loan with an indefinite maturity.

                     TITLE 26--INTERNAL REVENUE CODE

                        Subtitle A--Income Taxes


               Subchapter B--Computation of Taxable Income


Sec. 163. Interest

                      (4) Net investment income

        For purposes of this subsection--

        (A) In general

            The term ``net investment income'' means the excess of--
                (i) investment income, over
                (ii) investment expenses.

        (B) Investment income

            The term ``investment income'' means the sum of--
                (i) gross income from property held for investment 
            (other than any gain taken into account under clause 
                (ii) the excess (if any) of--
                    (I) the net gain attributable to the disposition of 
                property held for investment, over
                    (II) the net capital gain determined by only taking 
                into account gains and losses from dispositions of 
                property held for investment, plus

                (iii) so much of the net capital gain referred to in 
            clause (ii)(II) (or, if lesser, the net gain referred to in 
            clause (ii)(I)) as the taxpayer elects to take into account 
            under this clause.

        Such term shall include qualified dividend income (as defined in 
        section 1(h)(11)(B)) only to the extent the taxpayer elects to 
        treat such income as investment income for purposes of this 

        (C) Investment expenses

            The term ``investment expenses'' means the deductions 
        allowed under this chapter (other than for interest) which are 
        directly connected with the production of investment income.

        (D) Income and expenses from passive activities

            Investment income and investment expenses shall not include 
        any income or expenses taken into account under section 469 in 
        computing income or loss from a passive activity.

        (E) Reduction in investment income during phase-in of passive 
                loss rules

            Investment income of the taxpayer for any taxable year shall 
        be reduced by the amount of the passive activity loss to which 
        section 469(a) does not apply for such taxable year by reason of 
        section 469(m). The preceding sentence shall not apply to any 
        portion of such passive activity loss which is attributable to a 
        rental real estate activity with respect to which the taxpayer 
        actively participates (within the meaning of section 469(i)(6)) 
        during such taxable year.


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