Loans between parents and their children are nothing new. However, a little-known clause from the banking world can potentially save the entire family unit money and still provide working capital for the children who are inevitably paying off education debt, purchasing vehicles, purchasing homes and starting families. Simultaneously, this financial vehicle will minimize the tax consequences and annual paperwork required to legitimize the loan, in case of unforeseen future events in the child’s life prior to the loan being fully paid back such as a medical emergency or an unexpected divorce, for the parents.
Typically when loans are handled between parents and their child, the loans are defined as “demand” notes, which means after the initial distribution from the parent to the child, the child will pay the note off with periodic payments, each of which will have a principal portion and an interest portion. Demand notes operate much like a standard mortgage in that in the beginning, more of the payment is interest and a smaller amount of each payment is principal and as more of the principal is paid back the proportion changes such that the final payments are almost all principal and nearly no interest. In this scenario, the parents would need to file interest income from the private note on an annual basis on their 1040 and maintain a rather complicated schedule of payments with each payment listing the specific principal and interest until the note was satisfied.
Rather than setting up the loan as a “demand” note, if the loan were structured as a “term” loan, there are some major differences that would more readily make both the parent and child happier. With a term loan, all of the interest can be recognized immediately for the parents so they do not need to recalculate for any late or missed payments during the life of the loan and they only need to file the interest income on their current year 1040, thereby minimizing their tax burden in the future. Since we are at a low-point, historically, in interest rates and related-party interest rates are typically lower than commercial rates, this is a very viable and desirable consequence since most parents are not trying to extort the most interest from their children, they are just trying to help out and the interest issue is often more a legal formality than anything else.
To calculate the interest that will need to be reported on the parent’s 1040 in the initial year of the loan take these steps: Calculate the present value of interest at the applicable interest rate each month and sum these present values. Spreadsheet software typically has a function to calculate present values and advanced calculators can also do this calculation for you. Then schedule out monthly payments over the life of the loan. The difference is the imputed interest, which the parents claim on their 1040, maintaining the calculation as back-up support for this initial tax year only. The child then makes the payments monthly, since personal interest is not a tax deduction, there are no tax implications for the child regardless of whether or not the note is a “demand” or “term” performing note, but using the imputed interest calculation at the beginning of the note minimizes the total payments owed from the child to the parents. However, depending on the amount and the terms of the note as well as other factors on their tax return, the tax savings could be significant for the parents.
Comments