Help your family, but beware 'phantom interest'

Q: I plan to lend my son and daughter-in-law $100,000 to assist them in buying their first home, a condominium in Maryland. I have heard about a legal concept called "imputed interest" and don't want to get caught in some kind of Internal Revenue Service trap. Exactly what is "imputed interest?"

A: This is a complex area of law involving a number of sections of the Internal Revenue Code. In general, the IRS takes the position that if you make what it calls a "below market" loan, not only will it require that you pay some tax on the interest you did not receive, but it may treat a part of the transaction as though you gave your son a gift.

The law does not require you to pay any gift tax on amounts up to $1 million, though there is always the possibility that Congress could step in and change that. The recipient of the gift has no tax consequences.

How does one determine what is "below market"? This is easily determined by reviewing what is known as the applicable federal rate. Every month, the IRS publishes the AFR. These rates can be found at http://www.irs.gov/app/picklist/list/federalRates.html. They are broken into three main categories: short-term (up to three years) mid-term (three to nine years) and long term (longer than nine years).

For example, the AFR for a long-term loan issued this month is 4.10 percent. Accordingly, if you charge at least this interest rate on your loan, you will be in what the IRS calls a "safe harbor" and will not be penalized.

However, if you charge less than the applicable federal rate, there are two consequences. First, your son would be able to claim an interest deduction up to the AFR, even though he and his wife will not actually be paying that amount to you. Second, even though you will not actually receive that money, you will have to report it as ordinary income when you file your annual income tax return.

According to the IRS, "the borrower is generally treated as transferring the additional payment back to the lender as interest."

This is called "imputed interest," although many tax professionals use the term "phantom interest."

Here are some suggestions on how to avoid the issue:

Document the transaction. Have your son and daughter-in-law sign a promissory note and a deed of trust. The note will spell out all terms and conditions, including what the annual interest will be, when payments are due and the consequences of missing payments. You have to treat the transaction as if your borrower were a stranger.

The deed of trust must be recorded among the land records where the property is. Not only is this extra protection for you, but it will allow your son to deduct the interest. If a loan is not secured by a recorded deed of trust, the borrower cannot deduct the interest paid.

Have your son check with his lender as to whether he would be able to get a mortgage loan under these circumstances. Your loan would be a second trust. That means that the commercial lender would be in first place on the land records and you would be in an inferior position. Many lenders -- especially in today's economic climate -- may not be willing to make the loan if there is a large second trust placed on the property.

In order to avoid having this transaction be considered a gift, you have to satisfy yourself that your son will be able to repay the loan. You should get a copy of his current financial statement and the last two years of any employer statements of income received, usually the W-2.

Because the IRS is always looking for money, you have to make sure that your loan is really a loan. This is especially true when transactions are within the family. Have your attorney review the situation and prepare the necessary loan documents, which will then be recorded simultaneously when settlement takes place.

Benny L. Kass is a Washington lawyer. For a free copy of the booklet "A Guide to Settlement on Your New Home," send a self-addressed stamped envelope to Benny L. Kass, 1050 17th St. NW, Suite 1100, Washington, D.C. 20036. He cannot guarantee to answer all questions, but readers may contact him at blkass@kmklawyers.com.