You May Be Taxed for Loans to Children
Q: When a parent or grandparent helps out a young couple by giving them money for a down payment on a house, does this need to be noted with the Internal Revenue Service, either by the donors or the recipients? I expect that this money will be repaid when the house is sold in the future.--B. P. W.
A: What you’re really asking is whether you have to notify the IRS that you are loaning your children or grandchildren money to buy a house. And the answer is: yes, you do, in some way or another.
If your loan is secured by a trust deed on the house, you must report any interest you receive on the loan as ordinary income. The borrowers are allowed to deduct the payments as mortgage interest on their tax return. If the loan isn’t secured by a trust deed on the house, any interest payments you receive still must be reported as ordinary income. In this case, the borrowers would not be able to deduct the full interest payment on their taxes.
And even if you don’t charge interest--or if you don’t charge the rate set by the IRS as the minimum for loans between related parties--the IRS gets involved. In this case, the IRS deems you to have received the interest anyway--the service calls it “forgone interest”-- and you may be required to pay taxes on it. Further, if the forgone interest exceeds $10,000 per year, it poses gift tax consequences.
Let’s explain this final scenario more fully, because it is quite complicated.
For the sake of example, we’ll say you lent your daughter and her husband $50,000 to make a down payment on a home, and you elected not to charge them the IRS-set minimum interest rate, which we’ll peg here at a simple 8%. The minimum charge varies monthly, and you should check with your local IRS office, accountant or bank branch. That’s $4,000 in forgone interest to you each year.
According to Paul Hoffman of the Los Angeles law firm Hoffman, Sabban & Brucker, the IRS treats the $4,000 of forgone interest as taxable income to you. Further, it views the fact that you didn’t charge the interest as a $4,000 gift from you to your daughter and her husband.
Whether you have to pay income taxes on the $4,000 is now the question. Hoffman explains that the IRS makes an exception for loans of less than $100,000 and exempts the lender from reporting the forgone interest as ordinary income. One reason for the exemption is that Congress did not want to penalize parents for lending money to their children for college or a home purchase. But there’s a catch: If the borrowers have investment income--bank interest, stock dividends, for example--greater than $1,000 annually, then the lender must declare forgone interest in an amount equal to the borrower’s investment income.
Using our earlier example, the parents would not have to pay taxes on the $4,000 of forgone interest if their daughter’s investment income were less than $1,000. But if her investment income were $3,000, the parents would have to report $3,000 in forgone interest. As you no doubt can tell, this is a bit intricate, but perhaps you can understand the machinations better if you can see that the whole purpose of the tax code is to prevent relatives in a lower tax bracket from earning interest on money borrowed from a relative in a higher tax bracket. You see, the IRS, no matter what, wants its share.
Granting Extension to IRS Was Gamble
Q: In 1984, the IRS notified me that my 1981 return would be examined because of my involvement in a real estate tax shelter. They asked that I give them an extension to complete the review, and I complied. The review took four years, after which I was notified that I owed $8,200.
More than half of the $8,200 is interest on the tax penalty, and the reason the amount is so high is that it took the IRS so long to complete the review. Do I have grounds to contest this because the review lasted so long? Plus, now the state wants back taxes from 1981 based on the IRS actions. Isn’t there a statute of limitation?--R. E. S.
A: According to our legal experts, the position of the IRS is that your complaint would be groundless because you had use of all the tax penalty funds--the amount originally owed, plus interest--during the years the government should have had the money.
What about the extension and lengthly review? Our experts say if you had not agreed to the extension, the IRS simply would have required you to pay the disputed amount in 1985. By agreeing to the extension, you, in effect, gambled that you would emerge from the review unscathed.
As for the statute of limitation on your state return, our experts say the Franchise Tax Board has the right to review tax filings up to four years from the date of any change on your federal return.
Returning Funds to IRA Was Allowable
Q: I am 48 years old. I took a $2,000 premature distribution from my individual retirement account to tide me over while I looked for a new job. I know the Internal Revenue Service says if I roll this money over into “another” IRA within 60 days, I will not have to pay tax on the distribution. I put the $2,000 back into the same account within the 60-day period. Will I be taxed because I did not put the money into a new account? --A. R.
A: No. Your move falls within the IRS guidelines. You returned the money to a tax-deferred account within the allotted 60 days.
By the way, others have asked if the IRS permits borrowings from IRAs as you did. The answer is yes. But it should be made clear that the borrowings must be returned to an IRA account within 60 days or they will be subject to taxation. Further, the IRS allows taxpayers to move funds out of one IRA account to another only once every 12 months. For more information, see IRS Publication No. 590.
Carla Lazzareschi cannot answer mail individually but will respond in this column to financial questions of general interest. Write to Money Talk, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, Calif. 90053.
