What are the tax consequences of a forgiven loan made to a family member?
Generally, the recipient of a loan from a family member is not exposed to additional taxes if the loan is under a certain amount OR the loan is structured in a way that meets certain standards. A family member who voluntarily forgives a loan over $15,000 is considered to be gifting the value of the loan to the recipient. There are no tax consequences to the borrower of the money if the lender (family member) forgives the loan. However, if the lender was charging interest and the borrower defaulted on the loan then the borrower will experience tax consequences. A loan that is written off unwillingly, because it cannot be collected, is considered to be a non-business bad debt. This means that the lender has written off the loan to the borrower, which is referred to as cancellation of debt. In a situation where a taxpayer’s debt is cancelled the unpaid interest that would have been collected by the lender is considered income to the borrower by the IRS. While the cancellation of debt triggers an inclusion in income for the borrower, the lender can deduct the amount of the loan made and it will be classified as a non-business bad debt.
Tax Consequences for a Monetary Gift
The IRS is well aware that family members often attempt to avoid or reduce their tax liability by structuring loans, whether genuine or fake, to other family members. That is why charging interest is necessary to prove to the IRS that the loan is genuine. The most common scenario involves parents loaning money to their children for the purchase of a home. That type of arrangement means that the parents are the mortgage holders and the IRS will need to see that regular payments are being made by the child in order for parents to avoid tax consequences. If the loan is more than $15,000.00, a gift tax return would have to be filed by the giver, and if the gift exceeded the lifetime exclusion of $11.2 million (on gifts made in 2018 and before 2025), then gift tax would have to be paid by the giver. Loan recipients are not typically responsible for taxes due as a result of receiving a gift. (For gifts made and estates of decedents dying in 2016, the unified credit is $5.45 million.)
Giving a Monetary Gift Without Tax Consequences
However, there are ways to structure gifts to ensure that there are no tax consequences to either the gifter or the receiver.
Example 1: John and Mary wish to give their son and daughter in law $150,000.00 to purchase their first home. Instead of simply giving them the money, it can be structured as a loan, with proper interest being paid and claimed on John and Mary’s personal tax return, but they may gift to both their son and daughter in law $15,000.00 of mortgage principal forgiveness, per year, until the loan is fully satisfied.
Example 2: Joe wins the lottery and wants to share his new found wealth with his extended family, but cannot do so without suffering serious gift tax consequences. Therefore instead, Joe sets up a special account where he gifts each member of his family $15,000.00 per year at Christmas time, for as many years as it takes until the full amount he wishes to gift has been given. If Joe is married to Sally, and the winnings were a marital asset, then both Joe and Sally can each gift $15,000.00 to each family member on an annual basis.