Avoid Imputed Interest

First, imputed interest and all the crazy imputed income and gift tax problems generally do not apply when a loan totals no more than $10,000. However, watch out for this: The $10,000 limit applies to all outstanding loans between you and the lender, including those charging interest. But if the $10,000 rule does not help, you can turn to the $100,000 rule.




The $100,000 rule applies when the aggregate balance of all outstanding loans (interest-free or otherwise) between you and the lender is $100,000 or less. For income tax purposes, the amount of imputed interest is zero if the borrower's net investment income for the year is no more than $1,000. (Net investment income, which includes interest, dividends and certain royalties, but not necessarily capital gains, is the figure used to determine how much margin-account interest can be deducted on Schedule A.) Since most people who borrow money from family members are probably not sitting on large investment portfolios, imputed interest can generally be avoided.

Under the $100,000 rule, when the borrower's net investment income exceeds $1,000, imputed interest is limited to the actual amount of investment income. Here is an example: If a mother lends her daughter $100,000 interest-free but the IRS sets an interest rate of 5 percent, then the mother would have to declare imputed interest payments of $5,000. But if the daughter's investment income is less than $1,000, the imputed interest would be zero. If the daughter earned $1,500 in interest income, the mother would have to pay taxes on only $1,500 rather than $5,000.

To qualify for the $100,000 rule, the lender must collect an annual statement that discloses the borrower's net investment income.