02: Tax Issues: Gift vs. Loan
Since friends and family are more likely to give you a gift of money than any other lender or investor, you must understand the tax consequences of a gift of money versus a loan of money. There is a specific gift tax and a limit on gifts that can be given.
IRS Limits on Gifts
The IRS presumes that money transfers between family members are gifts, and applies the gift tax to the transfer. Generally, the donor pays the tax on the gift. For 2012, the IRS provided a gift tax exclusion for up to $13,000 per donee. This means that a donor can gift up to $13,000 to you in a taxable year before they have to begin paying gift taxes. A presumption means that without any action on your part to prove otherwise, the IRS will treat the money as a gift and tax the lender on any amount above $13,000. You will protect yourself and your lender from this happening by proving that the transfer was indeed a loan. Having both the promissory note and proof of your repayments provides documentation for the IRS in the event of an audit. You want to avoid the IRS thinking the loan is a gift because not only does your lender have to pay a gift tax, but your lender will have the loan counted against their gift limit. If changes to the arrangement reflected in the promissory note occur, such as your lender occasionally gifting you a repayment, you should consider consulting your accountant or attorney.
If you and your lender agree to a loan without interest, the IRS will “impute” interest into the transaction. The difference between the loan without interest and the loan with interest will be counted as a gift from the lender to you. The rate the IRS uses to calculate the imputed interest is the Applicable Federal Rate, or AFR. If the imputed interest exceeds $13,000 in the taxable year, then your lender will have to pay a gift tax on the imputed interest. This is not likely to occur in practice, as a loan would have to be enormous to generate $13,000 of interest at the AFR.