One of the tools we use when transferring real estate from parents to a child or among other family members is to purchase the property.
In Ohio real estate, lawyers use land contracts, lease purchase agreements, and real estate contracts to complete these transactions.
When sitting down and discussing the transaction before bringing it to an attorney, the family decides on a price, and the giver says, “I don’t want to charge you any interest on your payments.” They want to bless their loved one and see that the property stays in the family while getting the income they need to satisfy their financial needs.
When they bring this transaction to an attorney or their tax preparer, they find out that the IRS has an “interest” in whether they charge interest, and if they fail to charge what they consider market rate minimum interest, they may have a tax liability for that money they should be getting for interest.
The IRS has specific rules regarding interest charges on loans between individuals, including family members. These rules are designed to prevent tax avoidance and ensure that loans are treated as legitimate financial transactions rather than disguised gifts.
IRS Minimum Interest Rate Requirement
The IRS requires that a minimum interest rate be charged on loans between individuals, even if they are family members. This minimum rate is known as the Applicable Federal Rate (AFR). The AFR is published monthly by the IRS and varies based on the loan term:
– Short-term (up to 3 years)
– Mid-term (3-9 years)
– Long-term (over 9 years)
If a lender charges an interest rate below the AFR or no interest at all, the IRS considers this a "below-market loan".
Consequences of Not Charging the Required Minimum Interest
If parents sell a house to their daughter and son-in-law for $300,000 with payments over 15 years without charging the required minimum interest, several tax implications could arise:
1. Imputed Interest: The IRS will impute interest on the loan based on the AFR, even if no actual interest was charged. This means the parents would be required to report and pay taxes on the interest income they should have received, regardless of whether they actually collected it.
2. Gift Tax Implications: The difference between the AFR and the interest actually charged (in this case, zero) may be considered a gift from the parents to their daughter and son-in-law. If this imputed interest, combined with any other gifts given in the same year, exceeds the annual gift tax exclusion ($18,000 per individual as of 2024), the parents may need to file a gift tax return.
3. Original Issue Discount (OID): The loan may be treated as having OID, which is the difference between the stated redemption price at maturity and the issue price of the loan. This could result in additional taxable income for the parents over the life of the loan.
4. Potential Penalties: If the parents fail to report the imputed interest income on their tax returns, they may face penalties for underreporting income.
How to Avoid Issues
To avoid these complications, the parents should consider the following:
1. Charge at least the minimum AFR interest rate on the loan.
2. Document the loan with a formal, written agreement specifying the interest rate, repayment terms, and other conditions.
3. Treat the loan as a legitimate financial transaction, keeping records of payments received.
4. If they wish to provide financial assistance, consider charging the AFR and then gifting back the interest payments, up to the annual gift tax exclusion limit.
By following these guidelines, the parents can help ensure their loan is recognized as a legitimate transaction by the IRS and avoid potential tax complications and penalties.
Before you prepare an agreement to sell real estate with payments over time it is important you investigate your options regarding charging interest so that you don’t end up with an unexpected tax bill at the end of the year and many years after!
Schroeder Law Group advises clients who need a real estate lawyer in or near Hillsboro Ohio. We also help clients in and around Hillsboro with estate planning, general real estate, probate and business/nonprofit representation.
Call (937) 402-2348 or schedule a strategy session on our schedule page.