Welcome to the Tax Insights Podcast, where we break down complex tax topics into bite-sized how-tos. In this episode of Tax Insights Podcast, Jeff Dvorachek sheds light on why charging interest on such loans is essential, unraveling the complexities and implications for both lenders and borrowers alike. Tune in now!
Join us on today’s episode of Tax Insights as Jeff dives into an often-overlooked aspect of personal finance: interest rates on personal family loans. Discover why charging interest on such loans is not just a choice, but a legal requirement, and learn how the IRS ensures compliance even within familial transactions.
Host: Today, Jeff, on the program. Interesting topic. A topic I don’t think we have ever covered here on this program in all of the years doing the show and it is talking about loans but more specifically interest rates on personal family loans. You and I were talking before the show began, Jeff. I did not know that if you receive a personal loan from an individual that they have to legally charge you interest. Walk us through this.
Jeff: Right. And we saw this a lot in the past but we’re seeing it even more now as interest rates start to creep up. You know, if you go to the bank and you get a personal loan or you get a loan for a house, that loan is going to be somewhere between maybe six and a half to maybe eight and a half percent interest. And sometimes that’s unaffordable to people. So what they’ll do is they’ll talk to family members and see if the family member will actually lend them money. And at that time, yes, the family member really has to charge that person interest.
Host: I did not again, I don’t, I never knew this. I didn’t know if more of our listeners know this as well, too. Does that family member then have to claim that interest that they received as part of income?
Jeff: They do. So the one that loans the money, let’s say that they get $10 worth of interest, that $10 is taxable income on their return because they, you know, received more than the principal amount. So even again, if that individual does not want to get, they don’t want to make money off of anything, they just want to help a family member. They are still obligated to charge the interest rate for that family individual.
Host: Can they then give that money back to them as, as a gift at the end of the loan?
Jeff: They certainly can, but it’s still going to cost them tax because you still have to pick that interest up on your tax return. Now what the IRS says is they say if you have a loan to anybody, family member or non-family member of $10,000 or more, you’re required to charge a certain amount of interest. And that’s called the Applicable Federal Rate. And that rate really depends on whether it’s a short-term loan, a mid-term loan, or a long-term loan. You know, we were talking before that, you know, interest rates in the bank can be like six, seven, eight percent. But for a long-term loan, the minimum that the IRS will allow you to charge is somewhere around, right now it’s about 4%. So there is definitely a tax and interest savings there by, you know, loaning it from a family member.
Host: Why would the IRS require this for a personal loan? Like why does the IRS care if you want to loan out your money?
Jeff: So you know, at the end of the day, your taxed on your worldwide income, right? So if I loan you $10,000 here and you pay me $10,500 back or you may pay me $10,000 back. There’s still some benefit that I received on that and the IRS of course wants to tax that benefit and they’ll tax it whether it’s, you know, the interest rate that you charge or they’ll just impute the interest based off of what you should have charged. So no matter if you charge interest or not, they’re still going to get their taxes out of it.
Host: Interesting. Jeff, a lot of great information. And again, this is why I think listeners, you need to surround yourself with experts in the field so that you don’t break a law knowingly or unknowingly. And in this case scenario, I think a lot of people may not realize that if you do a personal loan, you have to legally charge that individual an interest rate. Yes, it’s lower than what the banks are at, but you still have to do that. And there’s really no way around that, Jeff. Is there?
Jeff: Yeah, that’s right. And from the IRS point of view, that is correct.
Host: Jeff, great information. Thank you for sharing with our listeners. How would our listeners connect with you and the team over at Hawkins Ash?
Jeff: I would go to our website, which is HawkinsAsh.CPA and go to that CPA HQ section. A lot of good information there.