Tax Treatment of Below Market ( Gift ) Loans

Occasionally when preparing tax returns, we encounter situations where there are loans between family members, or occasionally between employer and employee, with no interest being charged or the rate of interest is below market rates.  IRC Sec. 7872 deals with issues related to below market loans including: creating interest income, interest payments, investment interest, gift consequences and certain exceptions to the Sec 7872 treatment.  Sec 7872 covers a variety of circumstances; however this article deals only with its application to non-business loans between family members or between employer and employee. 

Below-Market-Loan – A below-market loan (Sec 7872(a)(1)) is generally a gift or demand loan where the interest rate is less than the applicable federal rate (AFR). The code defines the term “gift loan” as any below-market loan where the forgoing of interest is in the nature of a gift, while a “demand loan” is any loan which is payable in full at any time on the demand of the lender. (Secs 7872(f)(3); 7872(f)(5)) The AFR is established by the Treasury Department and posted monthly.  As an example, the AFR rates for May 2017 were: 

Term

AFR (Annual) May 2017

3 years or less

1.15%

Over 3 years but not over 9 years

2.04%

Over 9 years

2.75%

 

A term loan (defined in the Code as any loan that isn’t a demand loan) can also be a "below-market" loan if the amount loaned is more than the present value of all payments due under the loan (Code Sec. 7872(e)(1)(B)).

Tax Treatment – Generally, for income tax purposes:

Borrower – Is treated as paying interest at the AFR rate in effect when the loan was made and the interest is deductible for tax purposes if it otherwise qualifies. However, where the loan amount is $100,000 or less, the amount of the forgone interest deduction cannot exceed the borrower’s net investment income for the year.

Lender – Is treated as gifting to the borrower the amount of the interest between the interest actually paid, if any, and the AFR rate. Both the interest actually paid and the forgone interest are treated as investment interest.

Exception - The below-market loan rules do not apply to gift loans directly between individuals where the loan amount is $10,000 or less.   This exception does not apply to any gift loan directly attributable to the purchase or carrying of income-producing property. (Sec 7872(c)(2))

Employer and Employee - Loans between employer and employee, or independent contractor and the contracting person, are subject to the same rules except that the forgone or below market interest is treated as compensation to the employee or independent contractor. (Sec 7872(b)(1)(B))

August 10, 2017 by Lee Reams Sr.
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