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The Tax Implications of Interpersonal Loans

Lending and borrowing money is at the heart of the American economy. Not all loans go through the bank or are even on the books, however, as many people turn to family or friends to help make ends meet. Generally, the IRS is not overly concerned with small interpersonal loans. Larger loans, on the other hand, may be met with scrutiny. If you’ve given or received an interpersonal loan in the past year, it’s important to know your tax obligations.

There are several factors that may lead to the IRS treating a loan as income, in which case it may be taxed as such. These factors include the size of the loan, whether interest was charged, and if it was paid back.

The IRS may not care about a loan of a few hundred or even a few hundred dollars. Their interest may be piqued, however, when a personal loan takes the place of a more conventional loan, such as a mortgage, but with no interest charge. With compound interest, a $100,000 mortgage paid back over 30 years ends up costing nearly twice that. If a wealthy relative steps in a loans the $100,000 with no interest, the savings realized are seen as income – and taxed as such by the IRS. The tax implications of a loan this size should be discussed with an accountant, as this is not likely to be covered in Turbo Tax or other tax prep software.

Generally, interest savings are seen as a gift if the total value of the loan exceeds $14,000. So a $10,000 loan that is immediately paid back may not be a gift, but the same loan paid back over 5 years could be.

Be careful that your loan is not considered a gift. Gifts are more likely to be taxed by the IRS, and if your intention is to be repaid, there are a few steps you can take to make the distinction clear. Most importantly, you can set out a contract with the terms of the loan clearly spelled out, including amount, interest and payment schedule. Both parties should sign the contract and keep a copy of it in case the IRS comes calling.

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