When your sister-in-law asks for a loan for a great business opportunity, you generally want to exercise caution. Even aside from the perils that come with mixing money and family, making loans to family members and friends can result in a surprising tax bill. If you’re not careful, what you thought was a gesture of goodwill can turn into a nightmare with the IRS.

Loans Bearing a Market Rate of Interest

When friends and family members loan each other money at a market rate of interest, the loans are subject to the same tax rules governing loans between an individual and an unrelated third party. The person lending the money must report the interest payment as income on his or her yearly tax return. If the person borrowing the money uses the loan proceeds for business purposes, he or she is entitled to a deduction in the amount of the interest paid. No deduction is allowed if the proceeds are used for personal or non-business purposes.

Loans with No Interest or Below-Market Interest

Friends and family members often make loans to each other without charging any interest or charging only a nominal amount, since such loans are generally made as a favor to the borrower and not for the purpose of earning a profit. If you are a party to this type of loan, it’s important for you to know about the applicable tax rules so a generous gesture doesn’t result in a nightmare with the IRS.

In the case of no-interest loans, most people believe there is no taxable income because no interest is paid. The IRS doesn’t view it that simply. In fact, the tax rules are astonishingly complex and counterintuitive when it comes to no-interest loans. Even though no interest is paid to the lender, the IRS will treat the transaction as if the borrower paid interest at the applicable federal rate to the lender and the lender subsequently gifted the interest back to the borrower. This treatment results in two taxable events: income to the lender and a gift to the borrower. The lender is taxed on the imaginary or “imputed” interest income and, depending on the amount, may also be liable for gift tax on the imaginary payment made back to the borrower. As they say, “No good deed goes unpunished”!

In the case of a loan with a rate of interest below the applicable federal rate, the IRS will treat the transaction similar to a loan with no interest; however the amount of “imaginary interest” will equal the difference between interest calculated at the applicable federal rate and the amount of interest actually paid.

Exceptions

Fortunately, many loans between friends and family members are exempt from the harsh “imputed interest” rules explained above. For example, loans for $10,000 or less are exempt as long as the loan proceeds are not used to purchase income-producing assets. For income tax purposes, imputed interest on loans for more than $10,000 but less than $100,000 is limited to the borrower’s net investment income for the year, and no interest is imputed if the borrower’s net investment income is less than $1,000. However, the imputed interest rules will apply for purposes of the gift tax.

Overseas Loans

Loans to US citizens or residents from individuals residing outside the US are often exempt from the harsh imputed interest rules; however, where interest is actually paid, it is subject to strict reporting requirements. Any interest payments must be reported on IRS Form 1042-S, Foreign Person’s US Source Income Subject to Withholding. Because interest paid to a foreign person is generally exempt from income tax, under most circumstances, no tax on the interest is owed.

On the other hand, loans made to a foreign person from a US citizen or resident are subject to the same imputed interest rules as those applicable to domestic transactions.

The Bottom Line

If you’re considering making a loan to a friend or family member, do your homework first. In most cases, these loans will fall into one of the exceptions outlined above. However, if the loan proceeds are used for investment purposes, the borrower has investment income, or the loan amount exceeds $100,000, you might have a pretty complicated tax transaction on your hands.  Be sure to check with an accountant before making any significant loan.

On the bright side, if you’re looking for a way out of making that loan, potential problems with the IRS can be a good excuse!