What are the tax consequences of a forgiven loan made to a family member?

Generally, the recipient of a loan from a family member is not exposed to additional taxes if the loan is under a certain amount OR the loan is structured in a way that meets certain standards. A family member who voluntarily forgives a loan over $15,000 is considered to be gifting the value of the loan to the recipient. There are no tax consequences to the borrower of the money if the lender (family member) forgives the loan. However, if the lender was charging interest and the borrower defaulted on the loan then the borrower will experience tax consequences. A loan that is written off unwillingly, because it cannot be collected, is considered to be a non-business bad debt. This means that the lender has written off the loan to the borrower, which is referred to as cancellation of debt. In a situation where a taxpayer’s debt is cancelled the unpaid interest that would have been collected by the lender is considered income to the borrower by the IRS. While the cancellation of debt triggers an inclusion in income for the borrower, the lender can deduct the amount of the loan made and it will be classified as  a non-business bad debt.

Tax Consequences for a Monetary Gift

The IRS is well aware that family members often attempt to avoid or reduce their tax liability by structuring loans, whether genuine or fake, to other family members. That is why charging interest is necessary to prove to the IRS that the loan is genuine. The most common scenario involves parents loaning money to their children for the purchase of a home. That type of arrangement means that the parents are the mortgage holders and the IRS will need to see that regular payments are being made by the child in order for parents to avoid tax consequences. If the loan is more than $15,000.00, a gift tax return would have to be filed by the giver, and if the gift exceeded the lifetime exclusion of $11.2 million (on gifts made in 2018 and before 2025), then gift tax would have to be paid by the giver. Loan recipients are not typically responsible for taxes due as a result of receiving a gift. (For gifts made and estates of decedents dying in 2016, the unified credit is $5.45 million.)

Giving a Monetary Gift Without Tax Consequences

However, there are ways to structure gifts to ensure that there are no tax consequences to either the gifter or the receiver.

Example 1:   John and Mary wish to give their son and daughter in law $150,000.00 to purchase their first home.  Instead of simply giving them the money, it can be structured as a loan, with proper interest being paid and claimed on John and Mary’s personal tax return, but they may gift to both their son and daughter in law $15,000.00 of mortgage principal forgiveness, per year, until the loan is fully satisfied.

Example 2:  Joe wins the lottery and wants to share his new found wealth with his extended family, but cannot do so without suffering serious gift tax consequences.  Therefore instead, Joe sets up a special account where he gifts each member of his family $15,000.00 per year at Christmas time, for as many years as it takes until the full amount he wishes to gift has been given.  If Joe is married to Sally, and the winnings were a marital asset, then both Joe and Sally can each gift $15,000.00 to each family member on an annual basis.

Tax Consequences of a Forgiven Loan to a Family Member: Case Studies

Case Study 1: Loan Forgiveness With Proper Documentation

A parent lends $50,000 to their child to help with starting a business. After a few years, the business fails, and the child is unable to repay the loan. The parent decides to forgive the loan entirely. In this case, since the loan forgiveness is voluntary and the amount exceeds $15,000, the parent will need to file a gift tax return.

The forgiven loan amount will be considered a gift, and if it exceeds the lifetime exclusion limit, gift tax may be owed. The parent consults with a tax attorney who helps them navigate the gift tax rules and file the necessary documentation to ensure compliance with tax laws.

Case Study 2: Loan Default and Non-Business Bad Debt

A sibling loans $20,000 to another sibling for educational purposes. However, the borrower is unable to repay the loan, and the lender decides to write off the debt as a non-business bad debt. As a result, the lender can claim a deduction for the loan amount as a non-business bad debt on their tax return.

The borrower, on the other hand, will need to report the canceled debt as income and include it on their tax return. To understand the tax consequences and navigate the process, both siblings consult with a tax accountant who specializes in debt forgiveness and cancellation.

Case Study 3: Structuring a Loan as a Gift

A grandparent wishes to help their grandchild with a down payment on a house. Instead of giving the money directly, they decide to structure it as a loan with proper interest payments. However, the grandparent also wants to provide some financial assistance without triggering gift tax consequences.

They consult with a financial advisor who suggests structuring the loan in a way that allows for annual forgiveness of a portion of the principal, up to the annual gift tax exclusion limit. By doing so, the grandparent can provide financial support to their grandchild while minimizing potential tax consequences.