What’s the best way to help a family member with a private mortgage? Depending on how your structure the interest rates, you may face issue with the IRS.
Q: I set up a private 15-year mortgage with my niece several years ago at 3.5 percent interest. The paperwork is all properly filed. She is down to about 8 years left on the loan term and we decided at the beginning of the year to reduce the interest rate as she’s fallen on some hard times.
If we lower the interest rate to the Applicable Federal Rate, which is 1.65 percent for mid-term mortgage, the reduction would save her quite a bit of money. However, I don’t really need the money so I’d like to lower the interest rate to zero percent. It is my understanding that the the IRS would treat the interest I should be collecting like a gift.
Is a zero percent loan a smart way to go for a loan to a family member? The remaining balance on the loan is about $100,000.
A: The interest your niece pays to you is probably deductible to her on her federal income taxes if she itemizes. On the other side of the coin, the payments she gives you are interest income to you. You didn’t mention your financial situation and what that interest income does for you or how it affects your federal income taxes.
You are correct that if you reduce the interest rate on the loan to zero percent, the IRS will treat the interest your niece should have paid you as a gift you her. Given that the loan balance and interest rates are pretty low, the “gift” won’t cause a tax burden to you. You’re entitled to give anybody you please up to $15,000 without tax consequences and without triggering any gift tax reporting requirements.
So, yes, one of your choices could be to reduce the interest rate to nothing, but your niece would still have to make principal payments on the loan. Her interest payments may be around $150 per month. If she truly is in financial straits, we don’t know if the $150 per month will be enough to really help her out. Based on the limited information in your question, your niece is eight years into her 15-year loan. At this point, each payment she makes to you will go towards paying down the principal balance. If you reduce the interest to zero, everything she pays you will go towards reducing the principal balance of the loan.
Having said all that, we wonder what the purpose of the loan was eight years ago. There are times family members give money to other family members to help them out. In some cases, the person helping out gives the family member a gift of money without the expectation of repayment. In other situations like yours, you lent the money and expected to get it back.
If you still want to get the $100,000 back, reducing the interest rate is a nice gesture. But what about this? Sit down with your niece and figure out how bad her financial situation is and where it’s heading. If her problems are getting worse, maybe she needs advice as much as she needs either a break in her payments (to get herself back on track) or a reduction of principal.
Don’t get us wrong, reducing the interest rate may be something that your niece would welcome. But perhaps there is a larger, more meaningful way you can help. Giving her a year-long break on the payments or gifting her a chunk of principal (you can give her up to $15,000 tax-free per year) might help more.
Sit down and have a heart-to-heart talk to your niece and discuss with her the situation she’s in, what she can do to help herself, and then ask how you can help.