Different Types of Gift Loans and How They Work

Gift loans are defined as below-market or no-interest-rate loans made to either friends or family members. The most typical gift loans are made between parents and children. In the past, these loans were often used as an income tax strategy to reduce taxes. For example, higher-income parents would use these arrangements to shift income to their children, who often were in lower tax brackets. However, recent IRS rulings have curtailed the ability to shift income in this manner.

Types of Gift Loans

Gift loans generally fall into two categories. First, there are demand loans. As the name suggests, these loans are due at any time. In effect, a demand loan is due and payable whenever the borrower demands repayment. Therefore, a demand loan has no prearranged repayment schedule.

By contrast, the other type of gift loan does have a specific repayment schedule based on a certain period. Therefore, it is known as a term loan. A term loan is due and payable according the terms of the prearranged agreement.

How They Work

By definition, gift loans are no- or low-interest-rate loans. Therefore, the loan is not actually considered a gift. However, in the case of no-interest-rate loans, the interest is considered a gift. For low-interest loans, the difference between the prevailing market rate and what the lender actually charges is also considered a gift. As mentioned earlier, recent tax laws have limited some of the tax advantages to lenders. This was accomplished by a concept called imputed income and dollar limitations.

Tax Implications

Imputed income means that the “gift" in these types of loan arrangements can be considered taxable income at the end of year in certain instances. Although the lender does not actually receive interest payments, the amount the lender would have received is “imputed” or deemed received. For tax purposes, the borrower would also be deemed to have paid the interest. Therefore, the lender may be required to report the imputed income for tax purposes. If allowed, the borrower may also qualify for a tax deduction for the imputed income.

Gift loans for $10,000 or less are exempt from imputed income as long as the proceeds are not used for investment purposes. When gift loans are made for investment purposes, the amount of investment income the borrower has is used to determine if there will be imputed income. If the borrower has $1,000 or less in investment income and the loan amount is not more than $100,000, then there is no imputed income. If the borrower has more than $1,000 in investment income, then there is imputed income. However, the amount of imputed income is capped by the actual amount of the borrower’s investment income. For example, Smith makes Jones a $100,000 interest-free loan. Jones invests the $100,000 and has $1,500 in investment income. The imputed income is this situation would be $1,500. If Jones had $1,000 in investment income, the imputed income would be zero.