Parents Can Fall Into Tax Trap With Gift Loans

* Regrettably, lending money to children interest-free is a trap for the unwary [“Parents Can Give Till It Hurts, and in Tax Terms, That Can Take a While,” Money Talk, Nov. 22]. Interest-free loans are usually made by persons with sizable estates, not by persons whose estates are under the $625,000 or even the $1-million floor. Not surprisingly, this area of the Internal Revenue Code is complex and, to say the least, bizarre.

An interest-free loan from a parent to a child is known as a “gift loan” and each year the forgone interest is treated as a gift. The amount of the gift equals the interest calculated at the “applicable federal rate” . . . not 10% or even 15%.

The applicable federal rates, known as AFRs, are set by the IRS each month for short-term, mid-term and long-term loans. This forgone interest is the amount of the gift each year, so long as the loan is outstanding. Usually, the parent who makes an interest-free loan to a child is already using his annual $10,000 exemption so the amount of the forgone interest is applied to and reduces the lifetime exemption, which is currently $625,000. This requires filing annual gift tax returns.

The AFR for November, at the annual short-term rate, is 4.47%. If the parent is in the highest estate tax bracket with an estate of $3 million or larger, each $1,000 of forgone interest will ultimately cost the parent’s estate $550 in estate taxes. If the parent is in the lowest estate tax bracket with a $700,000 estate, each $1,000 of forgone interest will ultimately cost the parent’s estate $370 in estate taxes.

In addition to the gift tax, income taxes of the parent must be considered. In each year when the total interest-free loans between parent and child exceed $100,000, the parent must include the total amount of forgone interest for the year as income in his federal and state tax returns and pay income tax thereon.

During such time as the total amount of loans is less than $100,000, then the parent only includes as income the amount of the child’s “net investment income” for the year, provided that such “net investment income” exceeds $1,000. If the child’s “net investment income” does not exceed $1,000 for the year and the aggregate loans are less than $100,000, then the parent does not take any interest into income.

This is a small example of the complexities of the tax laws.

MARVIN GOODSON

Goodson & Wachtel

Westwood