Demand a Demand Loan

So far, so good. Unfortunately, the $100,000 rule gets really tricky when it comes to the gift tax. The net investment income rule does not apply here. To minimize gift tax problems, designate the interest-free advance as a "demand loan." This means the lender can demand full repayment at anytime. While this may seem unduly threatening, it could save your lender money because of the way the IRS calculates the imputed gift. You can still informally agree on a repayment schedule. With a demand loan, the amount of the imputed gift is calculated on a yearly basis and will total less than $11,000 a year, so the imputed gift for each year the loan is outstanding will fall harmlessly below the $11,000 annual limit for tax-free gifts.

But if you do not designate the loan a demand loan, the IRS will add up all the interest you would pay for the life of the loan and count it as a gift in the year the loan is made. The result could be a relatively large imputed gift that exceeds the $11,000 annual tax-free limit, and also cuts into the lender's gift and estate tax exemptions.





These rules can get tricky, though, so it is probably a good idea to consult a tax pro before drawing up this kind of loan. The IRS will let you avoid all these hassles if you simply charge interest on the loan. The IRS uses what it calls applicable federal rates, which change monthly, to determine if the interest rate is proper. If the lender charges at least the applicable federal rates, he simply reports the interest payments as taxable income.