Today TaxMama hears from Val in Washington, who tells us, “This past year a relative of ours loaned us $70,000.00 to help us build our vacation home. This incredible gift of trust was loaned to us without interest. We are just finishing up the project and will repay the loan in full when we re-finance the mortgage on our property.
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My domestic partner and I are both self-employed and we file our taxes separately since we are not legally married. What if anything do we need to say about this loan to the IRS? If either of us were ever audited they obviously would wonder why we didn’t report the $70K deposited in our names? We opened a separate building account to disburse the funds as we built our cabin.
Well Val,
Have you ever heard the old adage – No good deed goes unpunished?
Oh well – I’ve got good news for you – and bad news. And more good news.
The loan, as you’ve realized, isn’t taxable. And you’ve had the good sense to put the money into a separate bank account to pay all the construction costs.
Well done. Just keep the records proving it was a loan – and that you’ve paid it back – when you do.
The bad news? There’s no such thing as an interest-free loan.
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You’re going to have to face your very generous relative and tell her that she will have to pay tax
on the interest income she didn’t receive. That’s a concept called imputed interest.
The interest rate to use is the Applicable Federal Rate (AFR) for the month the loan was created.
Here’s a table with the interest rates for the past year.
https://tax.cchgroup.com/taxbuddy/afr.asp
If the loan was for less than a year, you would use the short-term rates. If your payment was all in one lump sum, you’d use the annual, or semi-annual rates (if you’re paying it off in half a year).
More good news for you is – you get a deduction for the interest you didn’t pay.
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Eerie, isn’t it?
Of course, you are always welcome to give your relative a gift of enough money to pay the taxes on the interest she never received – about 0.
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And you may have a deduction for the interest you never paid – or you’ll get to add it to the cost of the cabin as construction period interest.
Do you see all the complexities that arise from a simple, generous transaction?
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Remember, you’ll find answers to questions about generosity and all kinds of tax issues, free. Where? Where else? At TaxMama.com
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- Commerce Clearing House :: Applicable Federal Rates (AFRs)
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