No-interest loan from parents prompts question

Q: My husband and I bought our first home last year and my parents loaned us $44,000 so we could get a better mortgage deal. We are making monthly payments on this loan but my dad told us he would not charge us interest. After a discussion with a tax preparer I am concerned that there is some additional tax reporting that we will have to do for this loan. I was told this is because the loan is below market due to the lack of interest. The preparer asked me to provide details of the loan when we bring our information for the 2020 tax return. Before doing this I want to have some idea of what the effect will be on us. Can you give us a summary of what we might have to report?

A: Let me start by stating that, in the end, there is a good chance that you don’t need to report anything. But it is important that you understand why so you can discuss the issue with the preparer if you hear a different answer.

The tax law does have rules for below market loans, which means a loan where the interest rate is below a rate that is published each month by the IRS. This target rate is a “risk-free” rate determined by what U.S. Treasury securities of a similar term are paying.

To illustrate let’s assume the target rate is 2%. The law generally requires that the loan call for at least this 2% interest or both the lender and the borrower will be required to act as if 2% was charged (again this is just a sample rate).

The end result is to deem the loan to call for the required rate, and to then assume that the lender, who has provided a benefit by not charging this interest, gives the interest to the borrower. Since the borrower doesn’t really get this, or the lender give it, the law then assumes the borrower gives the interest back to the lender.

In your case, if the transfers occur each year, and I use $44,000 as the full year outstanding balance, we assume that your parents give you $880 (2% of $44,000) as a gift and you then give them $880 back as a payment of interest.

So what is done is to measure the benefit you receive by not paying “fair” interest and then ask what if the lender actually did give you the $880 benefit which you then returned as a payment of interest.

Two things would result for tax reporting purposes. First, your parents would need to act as if they made an $880 gift to you and your husband. Second, you could act as if you paid $880 of interest but your parents would need to act as if they received $880 of interest.

At this point everyone figures out what the tax result is. Let’s start with the gift. Gifts are not income to the recipient, so you report nothing. Gifts may need to be reported to the IRS but only if they exceed $15,000 per person each year.

If your parents did not make other gifts that would, with the $440 to you and $440 to your husband, exceed $15,000 to each of you, there is no reporting of this deemed $880 gift ($440 to each).

The interest may be a different story. But the law has a special exception that may apply. If the aggregate below market loans do not exceed $100,000 for the year, this interest transfer cannot exceed the net investment income you report on your tax return. If your investment income is $1,000 or less you can simply ignore this step.

Investment income includes interest and certain dividends and capital gains, but not “qualified” dividends or long-term capital gains. The end result may well be that you can ignore this interest reporting. If so, your parents also do not report interest income.

If the interest must be reported because your investment income is too high, you can only deduct the deemed interest paid if your parents have recorded a mortgage to perfect a secured interest in your home.

Jim Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at jimhamill@rhcocpa.com.