"Pass-through" loan to family member - taxable interest?

[Rapid Robert]

Suppose a parent has a HELOC mortgage on their home, and adult child needs a loan for next two years but can pay it back with even monthly payments. So parent borrows against HELOC and makes $15K loan to child, charging exactly the same interest rate that parent is paying to borrow via the HELOC. Parent then uses the monthly loan payments (principal portion) to pay down the HELOC For parent it is a wash, loan interest received equals loan interest paid.

Does parent need to report the interest income as taxable on the Form 1040? Is investment interest expense deduction only available if itemizing (I'm pretty sure a solid "yes" on that, without even looking).

I have scanned through Pub 550 (and even Pub 525) but did not find an immediate answer.

[Beersheba]

My opinion - I think the parents are entitled to the deduction (if they are able to itemize), the child is NOT entitled, and the parents are not obligated to report interest paid as a pass-through to parents...

IRS may take a more aggressive position if their reporting mechanism are sophisticated enough to detect what is going on. But if so, they are reaping where they haven't sowed. (Wouldn't be the first time).

[Rapid Robert]

I'm trying to dig further into the options mentioned in Pub 550.

For example:

"Exception for loans without significant tax effect. Loans are excluded from the below-market loan rules if their interest arrangements do not have a significant effect on the federal tax liability of the borrower or the lender. These loans include:

6. Other loans on which the interest arrange-ment can be shown to have no significant effect on the federal tax liability of the lender or the borrower."

Is there some benefit to trying to fit this loan into the "below market loan" rules? It seems that the current rate on the HELOC (4.5%) precludes this treatment since federal AFR is quite a bit lower than this.

I suspect there is no relief, and the parents in this scenario have full taxable interest income without any deductible interest expense (assuming they take standard deduction). But somehow it seems like there should be a sort of COGS treatment on the interest paid. From an economic point of view, there is no accession to wealth, the parents are not borrowing or lending money, they are just letting the relative "use" their access to secured lending for a lower rate than credit card interest.

[Burke]

I disagree. The HELOC loan is a contract obligation between the lender and the parents. They contractually owe the interest and can deduct it (if itemizing). It won't be considered a real "loan" to the child unless there is a written contract. If the interest paid by the child is the exact same interest rate the parents are obligated to pay, it should be at market rate. Parents should claim as income from child and could deduct (if itemizing). Child could deduct depending on what loan is for. Normal rules apply. If no written agreement, it could be looked at as a gift.

[FEDUKE404]

Isn't there an issue for parents to borrow against HELOC unless they affirm (I forget the jargon) "the new funds were used to maintain / improve their existing residence" ?
A lot of HELOCs have evaportated in recent years, to include those used to buy a new vehicle, pay for a vacation, et al.
The Form 1098 from the lender could also have some issues?
If the parents want to (separately) make a true "loan" to the child, then that is their option. Interest would be taxable to parents and non-deductible to child. Per the above, the parents likely have no new Sch A mortgage deduction either.
Trying to call this arrangement "investment interest" does not sound as if it would fly as the rules differ significantly, to include investment income limitations AND the need to itemize to benefit.

Sounds like another creative taxpayer end-run to me. . .

[Rapid Robert]

I disagree.

Actually, I think you agree. We are both saying the parents have taxable interest income. The interest on the HELOC is obviously not deductible as acquisition mortgage debt, and the investment interest expense deduction won't reduce the tax if they still take standard deduction.

"Isn't there an issue for parents to borrow against HELOC"

No. The funds from the HELOC can be used for any purpose. I've never heard of a HELOC where the borrower had to somehow provide evidence the funds were used for a specific, limited purpose.

"Trying to call this arrangement "investment interest" does not sound as if it would fly"

Of course it would. Interest income is by definition investment income, and under the interest tracing rules, the interest on the HELOC would be investment interest expense. The problem is that it has to flow through Schedule A or else be ignored.

"Sounds like another creative taxpayer end-run to me. . ."

That's why I asked the question.

So far I see 3 options:

1) ignore the taxability of the interest, but That Would Be Wrong. (however I liked Beersheba's remark about the IRS reaping where it did not sow...)

2) parents (or child) eat the artificial (non-economic) expense: either pay the tax, lower the interest rate on the loan to AFR, or gross up the interest charged to cover the tax

3) now here is some creativity:

The parent (one of them) has started a micro-lending business, reportable on Schedule C. Gross income is the interest received, and one of the expenses is the interest properly traced. So for the first year, net profit would be zero. There is even an activity code for this type of activity. The borrower could even issue a 1099-INT to the EIN of the Schedule C.

Possible problems? Maybe there is some licensing required by the state (but that is a civil issue with the state, not IRS, and taxpayer either gets the license or takes position the activity is not illegal).

Maybe the IRS says it is not a for-profit activity. OK, just charge the borrower a tiny bit more to yield a slight profit. Or maybe the IRS argues substance over form.

[FEDUKE404]

"Isn't there an issue for parents to borrow against HELOC"

"No. The funds from the HELOC can be used for any purpose. I've never heard of a HELOC where the borrower had to somehow provide evidence the funds were used for a specific, limited purpose."

================================================== =====

I disagree. Keep reading. . .

The Tax Cuts and Jobs Act (TCJA) of 2017 changed the deduction that allows taxpayers to deduct mortgage interest on a primary or secondary home, also known as a qualified residence. With the passage of this law, tax deductions on HELOCs are suspended from 2018 through 2026, unless you meet certain criteria.

When you can claim interest on a HELOC


The interest charged on a home equity line of credit can be considered tax deductible as long as it meets the following requirements:

• The loan must be secured by the taxpayer’s main home or secondary home (qualified residence).
• The funds borrowed with the HELOC must be used to either buy, build, or improve that same home (or homes).

This means that if you borrow from your primary home’s equity with a HELOC and use those funds to renovate the kitchen, build an addition to the home, or repair your roof, the interest charges on that HELOC are likely tax deductible.



When you can’t claim interest on a HELOC


On the flip side, your HELOC interest may not be tax deductible if it doesn’t meet the above criteria. So, if the home isn’t your primary or secondary residence, if you use the funds to improve a third property, or if you use the money for expenses not related to home improvement, you likely won’t be able to claim the interest on your tax return.

For example, if you pull equity from your home with a HELOC, then use those funds to pay off your student loans, go on vacation, pay off credit card debt, or buy an investment property, the interest probably won’t be tax deductible.

I apologize for the source. It's the first one that popped up and I didn't feel like digging through any IRS codes to pursue further:

https://www.foxbusiness.com/personal-finance/heloc-interest-tax-deductible


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"Of course it would. Interest income is by definition investment income, and under the interest tracing rules, the interest on the HELOC would be investment interest expense. The problem is that it has to flow through Schedule A or else be ignored."

You will need to provide me with a reference as to how to claim (any) HELOC interest paid on Form 4952, line 1 as "investment interest." That is definitely a fact unknown to me. . .


Since I don't want to be accused of "hijacking the thread" I'll just return now to my morning coffee.

FE

[Rapid Robert]

You will need to provide me with a reference as to how to claim (any) HELOC interest paid on Form 4952, line 1 as "investment interest." That is definitely a fact unknown to me. . .

See TheTaxBook page 4-11 (quote following). This has been around for a very long time. For example, you can borrow against the equity in your primary residence to buy a rental, and using the 10-T election, you can deduct the interest on Schedule E under the interest tracing rules. Same thing applies with investment interest expense.

"Election to Treat Mortgage Interest as Not Secured by the Home
10T election. A taxpayer can elect to treat any debt secured by his or her qualified home as not secured by the home. A taxpayer may want to treat a debt as not secured by the home if the interest on that debt is fully deductible (for example, as a business expense) whether or not it qualifies as home mortgage interest."

From the source you quoted:

"With the passage of this law, tax deductions on HELOCs are suspended from 2018 through 2026, unless you meet certain criteria."

This is sloppy writing. The tax law makes no reference to HELOCs, first mortgages, second mortgages or anything like that. It only mentions acquisition debt, equity debt (and pre 1987 grandfathered debt). What label the bank slaps on a loan is irrelevant, so talking about HELOCs like they are some special category is misleading. Also they are wrong about "through 2026", it is only through 2025. I suggest you remove this source from your bookmarks.

Now, I still want to know what's wrong if anything with creating the micro-lending business...(it's mentioned quite a bit if you search for it, where individuals can engage in this type of business).

[FEDUKE404]

See TheTaxBook page 4-11 (quote following). This has been around for a very long time. For example, you can borrow against the equity in your primary residence to buy a rental, and using the 10-T election, you can deduct the interest on Schedule E under the interest tracing rules. Same thing applies with investment interest expense.

"Election to Treat Mortgage Interest as Not Secured by the Home
10T election. A taxpayer can elect to treat any debt secured by his or her qualified home as not secured by the home. A taxpayer may want to treat a debt as not secured by the home if the interest on that debt is fully deductible (for example, as a business expense) whether or not it qualifies as home mortgage interest."

From the source you quoted:

"With the passage of this law, tax deductions on HELOCs are suspended from 2018 through 2026, unless you meet certain criteria."

This is sloppy writing. The tax law makes no reference to HELOCs, first mortgages, second mortgages or anything like that. It only mentions acquisition debt, equity debt (and pre 1987 grandfathered debt). What label the bank slaps on a loan is irrelevant, so talking about HELOCs like they are some special category is misleading. Also they are wrong about "through 2026", it is only through 2025. I suggest you remove this source from your bookmarks.

Now, I still want to know what's wrong if anything with creating the micro-lending business...(it's mentioned quite a bit if you search for it, where individuals can engage in this type of business).

Obviously you know everything and I know nothing. It gets tiresome after a while...............

I was not seeking an article worthy of a Pulitzer prize. . .my bad.

I will now halt my comments on this matter by stating my tax software has a box for "mortgage interest" where you must check a box certifying "all proceeds of the loan were used to buy, build, or maintain your main or second home." If the box is not checked, nothing goes to Schedule A. There is a second box that allows you to separate the qualifying home and non-home qualifying interest. The non-qualifying amount reduces the amounf on the Form 1098 that transfers to Schedule A.

Perhaps my software is also sloppy, but at least it IS consistent with the existing HELOC deductible rules as I understand them to be.

If you automatically deduct all HELOC interest as an allowable Schedule A deduction, I think you are in error. But since you are signing the tax returns, that's not my concern.

But, again, I obviously know nothing. You are free to contact the authors of the aforementioned article I provided to castigate them for their factual sloppiness.

That should maybe be paired with you might not quite know everything you continually espouse??

Anyway, I'm outta here. Good luck in your future and recurring fault-finding comments.

FE