Members of the Maryland Association of Certified Public Accountants are answering readers' tax questions through April 15.
Q: If we make a loan to a relative, in this case a daughter and son-in-law, do we have to charge them interest according to the tax laws and if we do, is the interest specified or is it something that we can set?
A: To avoid potential tax pitfalls, taxpayers should include a going rate of interest in the repayment terms of a loan made to relatives. If this is not done, the IRS presumes that the borrowers have made a gift of their forgone interest to the noteholders. The lenders are then required to report that amount as interest income on their return, whether actually received or not. An exception to the rule: if the loan is for less than $10,000, unless the loan is used to purchase income-producing assets. The lenders should also require a written agreement between the two parties, even when lending to relatives. If the borrowers default and collection efforts are unsuccessful, the lenders can then at least deduct the remaining loan balance as a nonbusiness bad debt on their tax return. With no written note, the IRS would view the loan as a gift and disallow any deduction for the uncollected portion.
