Helping family and friends: The best ways to make gifts, loans

WASHINGTON — At some point in your life, you may decide to give or loan money, a car or other property to a loved one and/or friend.

Whether you want to make a gift or a loan, there are a few things that will help you to do it correctly and avoid problems down the road with the IRS.

Making a gift:

A gift can be made in the form of cash or other property. Planning to give your adult son $10,000, or your nephew a new car? Those are both considered gifts.

But gifts also include a sale or exchange of property for less than its fair market value. In either event, if you give a gift to someone who is not your dependent, there are rules and limits that you need to know to handle the gift correctly.

Know the gift-tax limit:

In 2015, you may give up to $14,000 to any number of people without having to file a gift tax return.  As an example, Aunt Mary can give each of her three favorite nieces $14,000 per year, and neither the aunt nor nieces will owe any gift taxes or have to file a gift tax return (IRS Form 709).

However, the story changes if Aunt Mary wants to give $30,000 to each niece and $5,000 to her friend. Each of the $30,000 gifts will reduce Aunt Mary’s lifetime exemption amount by $16,000 each or $48,000 total ($30,000 — $14,000 = $16,000).

In this case, a gift tax return will also need to be filed.  It’s not until Mary uses up her full lifetime exemption amount of $5.43 million (2015 figure) that her gifts will become taxable.  Mary is then responsible for the gift tax liability, not her nieces. The $5,000 gift to her friend is less than the $14,000 annual exclusion, so nothing needs to be done.

Both the annual exclusion and gift tax exemption amounts are indexed for inflation so check with your estate planning attorney or financial planner at the start of every year for the IRS’ updated figures.

To learn more about how the gift tax works, including some important estate and tax considerations, visit Schwab’s Estate Tax and Gifting Limit.

Be aware of the exemptions:

There are two exemptions to the annual exclusion and lifetime exemption amounts that can help you when you are helping someone else.

  1. Paying education expenses directly to a school or university: This is a win-win for wealthy grandparents as they can remove a substantial amount from their estate while investing in each of their grandchildren’s futures. But, in order for it to count, the check must be made out to a qualified educational organization and be used to pay for tuition (room and board doesn’t qualify). In other words, the gift must be paid directly to Virginia Tech and not to grandson, John, who then pays Virginia Tech.

Read: The Best Ways to Save for College

  1. Paying direct medical expenses: Paying for qualified medical expenses, such as health insurance or treatment for an illness, works the same way. The check has to go directly to the health care provider and not to your loved one. However, if the expenses are reimbursed by health insurance, or if they are for cosmetic surgery that is not to correct disfigurements, the gift will count toward the $14,000 annual exclusion amount.

This IRS Guide to Medical and Dental Expenses is very comprehensive and explains all about paying medical expenses for someone who is a dependent.

Making a loan:

If you are a generous person and your family and friends know it, chances are you’ll be asked to lend someone money, if you haven’t already. It’s important to follow the IRS’ guidelines on what constitutes a loan, otherwise your loan could be seen as a generous gift.

This is particularly true if you have concerns about Uncle Bob not being able to make a payment or defaulting on the loan entirely.  Here are a few things you can do to protect yourself:

Create a loan document:

Before lending the money, create an enforceable note that outlines the loan amount. It should include a stated rate of interest that’s at least as high as rates set by the IRS for current market conditions (see the IRS Applicable Federal Rates for August 2015). It should also include the schedule of when each payment is due, the date the loan should be paid off entirely and any collateral.

You’ll also need to let your accountant know how much interest you receive each year so they can properly report it on your tax return. There are perils to not having a note in place. For more information, here’s a great guide to Promissory Notes for Personal Loans to Family and Friends.

Forgiving the interest or the loan:

If you forgive some or all of the interest, or even the entire loan after a passing of time, the IRS may rule that your loan was never a loan, but in fact a gift from the very beginning.  To further solidify your loan intentions, speak with your estate-planning attorney about how your executor can continue to collect interest payments after your death.

Giving someone a gift or helping them out with a loan is a generous act of kindness. By knowing how to handle gifts and loans correctly, you won’t regret your generosity later.

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