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Watch Out for Implications of Family Loans

BERKELEY HEIGHTS, N.J. ( TheStreet) -- Family loans can be appealing, given the current miserably low interest rates on savings accounts coupled with tight credit conditions for borrowers, but there are serious tax and relationship implications to consider first.

For example, let's look at a wealthy parent with a child in their late 20s or early 30s. The parent has excess cash earning close to zero in a money market account. Their adult child would like to buy their first home, since they're more affordable than during the crazy days of the housing bubble. But they are having difficulty getting a mortgage due to stricter lending rules.

Family loans typically come with low interest but serious tax and relationship implications.

A private mortgage might benefit both parties in this circumstance: The parent can earn a higher rate of return, while the child will be able to get mortgage funding at a lower rate than a traditional lender.

The key to making this work is to structure and document the loan properly. Failure to do so may give rise to unintended consequences, such as taxable imputed income taxes and gift taxes. If a borrower makes a zero-percent interest loan to a family member, the IRS deems the lender to have earned interest at the Applicable Federal Interest Rate and forgiven the loan interest. As a result, the imputed interest income is taxed on the lender's income tax return and the "forgiven interest" is considered a gift and eats into the lender's $13,000 (as of this year) annual gift tax exclusion. If the forgiven interest is greater than $13,000 a year, it would also eat into the current lender's Lifetime Gift exclusion of $5 million.

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