Imputed Interest

[Corduroy Frog]

A grandmother loaned her grandson $100,000 for home improvements, to be repaid $10K per year over 10 years. It is not known at this time who will be alive 10 years from now, but that doesn't affect the question.

There is obviously no intent to charge the grandson interest, as described above.

However, for tax purposes there is no such thing as an interest-free loan. For purposes of discussion, let's assume the imputed interest rate would create $4000 of interest in the first year.

May the grandmother consider this interest as an annual gift (which is clearly beneath the $13K reporting threshold)? And by doing so, may she avoid having to report the interest?

[New York Enrolled Agent]

However, for tax purposes there is no such thing as an interest-free loan. For purposes of discussion, let's assume the imputed interest rate would create $4000 of interest in the first year.

See if the taxpayer qualifies under §7872(d). No interest is imputed on a gift loan upto $100K if the borrower has net investment income less than $1,000.

[Nashville]

Another Twist

Great answer, NYEA, as it provides another possibility for avoiding the imputing of interest on a loan such as presented in the original post.

In this situation, the taxpayer DOES have investment income greater than $1,000, from holdings in excess of $250,000. Taxpayer normally would have qualified for a conventional loan but could not negotiate with his bank, as they wanted too much collateral. Bank was claiming new guidelines because of the fallout from the cash crunch, economy, and bailout.

Can the grandmother bail out of reporting imputed interest by gifting the interest in the amount of $4000 to her grandson? She is allowed up to $13,000 as an annual gift to him.

The economics are not so much a concern for the grandmother as the complications. Imputing of interest means the principal loan of $100,000 is reduced, meaning the grandson's basis is also reduced, even though the full amount will be spent. Paying taxes on the interest income would be offset by the grandson's deduction of interest expense, etc. The IRS doesn't win either way - the parties don't win either way, but the imputed interest does create paper complications.

[Davc]

Can the grandmother bail out of reporting imputed interest by gifting the interest in the amount of $4000 to her grandson? She is allowed up to $13,000 as an annual gift to him.

No. Not collecting the interest does not absolve GM of the requirement to report it.

Imputing of interest means the principal loan of $100,000 is reduced, meaning the grandson's basis is also reduced, even though the full amount will be spent.

No it doesn't. GM reports the interest income each year and GS reports the interest expense if he itemizes. And GS's basis is determined on what the improvements cost. The loan amount is irellevent other than being a source of funds.

[Nashville]

Good Answer

DavC - thanks for the answer. Your posts have a history of clearing up some muddled thinking on numerous occasions.

Your answer is what I expected and one I believe to be correct. Family transactions always seem to cause me a lot of trouble, and also are transactions that have clients emotionally charged up. Some people think they can do anything they want with their kinfolk and then escape tax repercussions because they are "family."

NYEA did shine some new light. Thanks folks.

[Burke]

No. Not collecting the interest does absolve GM of the requirement to report it.

Did you mean to say not collecting the interest does NOT absolve GM of the requirement to report it?

[Kram BergGold]

interest may not be deductible

If the 100k loan is not backed by the house then the interest whether paid or imputed is not dedcutible although it is reportable by the GM. My guess is this laon was neer recorded as a mortgage so poof to that deduction!

[Davc]

Did you mean to say not collecting the interest does NOT absolve GM of the requirement to report it?

Yep. That's what I typed but my keyboard must be malfunctioning.

[Burke]

Yep. That's what I typed but my keyboard must be malfunctioning.

Strange, but mine does that too on occasion.

[Zee]

This is a great thread, and something I never considered. It's not well publicized and I'm sure many tax preparers haven't even questioned clients whether they've received/made such a loan. I would think it would have been a question that should have be asked to almost every young couple buying their first home. Hopefully, most would fall into the exceptions.