By Tim Grant Pittsburgh Post-Gazette WWR Article Summary (tl;dr) Ahmie Baum, managing director of wealth management at UBS Financial Services in Pittsburgh says there is no right or wrong path in terms of a parent providing a loan or choosing to offer a gift to their child. There are just complications.
Parents often want to help their adult children who need a financial boost, and it frequently comes down to a choice of whether the help should be in the form of a gift or a loan.
There could be tax implications with either choice, depending on the dollar amounts involved.
The Internal Revenue Service is not concerned with most personal loans or gifts that a parent makes to a child, but when the dollar amount exceeds $14,000, the parent must file a gift tax return. And parents who loan a child as much money as it would take to purchase a home are required to charge interest on the loan or face penalties imposed by the IRS.
Pittsburgh certified public accountant, Howard Davis, president of Davis, Davis & Associates, said he has clients who make loans to their children. The loan documents may either have the child paying interest only, or principal and interest. Or, the child doesn't pay anything at all.
For September 2016, the minimum interest rate that the federal government will allow is 0.61 percent for loans up to three years; 1.22 percent for loans three to nine years; and 1.88 percent for loans lasting nine years or more.
"If the IRS determines that $1,000 interest is owed on the loan amount based on the Applicable Federal Rates that the IRS sets each month for private loans, the $1,000 is considered a gift from the parent to the child. The IRS will tax that $1,000 as interest income to the parent, which the parent must report as taxable income," Davis said.
"I see a fair number of these loans. I'm sure there are a lot more of these types of transactions I don't see," he said.
If parents forgive the loan or don't pursue collection actions, the IRS may conclude the loan is a gift and count the loan amount toward the parents' lifetime gift exclusion, which this year is $5.45 million. The exclusion is the amount a parent can give away over the course of a lifetime or as part of their estate.
The child is then required to report the loan amount as income and pay tax on it. The IRS does not always find out about private loans from parent to child because a lot of people may not bother to report them.
Ahmie Baum, managing director of wealth management at UBS Financial Services in Pittsburgh, said there is no right or wrong in what path a parent takes in terms of going with a loan or choosing to offer a gift. There are just complications.
"When you lend money among family members, you run the risk of having uncomfortable social relations as a result of this lending transaction," Baum said. "But gifting with certain requirements could also be beneficial. For instance, you could tell a child you will pay for their college education, as long as he or she maintains a 3.0 grade point average."
One financial adviser who often works with affluent clients who have considered these issues has concluded that when dealing with adult children it often makes more sense to go with the loan.
"If you provide too much financial support, you could dampen their drive to become financially independent," said Rebecca Pavese, a financial planner at Palisades Hudson Financial Group in Atlanta.
Researchers at Carnegie Mellon University in 2012 found the biggest risk of loaning money to a friend or family member is not the loss of the money, but the potential loss of a relationship.
In a detailed survey provided to 971 individuals, the researchers came away with two main findings.
They found borrowers had self-serving biases about personal loans. They are more likely to believe the loan was initiated by the lender and the loan had been paid off as agreed. If the loan was delinquent, they were inclined to feel it was a gift.
The second finding was that overdue personal loans had wide-ranging negative consequences, such as loss of closeness, loss of trust and lenders feel that the delinquent borrowers were going out of their way to avoid them.
Still, Pavese, a 16-year veteran financial adviser who also handles the administration of loans between parents and children, said a loan can be a great solution for a child trying to escape the burden of credit card debt or the fallout of other poor financial choices.
With "intrafamily loans," children pay less than they likely would if they borrowed from a bank and parents earn a decent return while helping children help themselves.
Her first rule is: Don't let your adult child's needs unbalance your own finances. "Never let helping your child jeopardize your retirement," Pavese said.
She acknowledges such loans can also cause tension in relationships if a child cannot or will not repay the borrowed amount.
"To avoid later headaches, make all terms of the loan clear and set them down in writing," she said.
After setting an interest rate that is at least as high as the AFR, Pavese said the next step is to set up a repayment schedule and decide in advance the penalty for failing to make payments on time.
"If your child defaults on a loan, there should be stated, concrete consequences, such as withholding of future gifts," she said. "At the very least, you should be very reluctant to lend again unless he or she demonstrates substantial improvement in responsibility."
If the loan is intended to be a mortgage on your child's primary home, you should hire an attorney to draft the note. The loan must be secured by the home and recorded under state and local law for your child to deduct the mortgage interest on his or her tax return.