By Curt Sheldon

Beyond the family dynamics involved when you partake in business transactions with a person to whom you are related, there are tax ramifications.

Imagine Junior is on his own now, and you want to help him. You loan him $50,000 for a down payment on a house. In the eyes of the IRS, you've just entered into a business relationship with Junior. Because you don't need to make money on the loan, you don't charge Junior any interest. What parent would charge their child interest on a loan if they didn't need the money? 

Well, the IRS says every parent would charge interest. In fact, the IRS sets a minimum interest rate a lender is assumed to charge. It is called the Applicable Federal Rate (AFR). The IRS will not allow you to charge less than this amount of interest on a loan to anyone other than your spouse. What happens if you don't charge the AFR-required rate? The IRS will impute interest. What this means, in essence, is the IRS will say you received interest income based on the AFR, and you will owe taxes on that income.

The IRS also will say the instant you received that income, you gave it back to Junior. In other words, you'll pay taxes on income you didn't actually receive. There are exceptions, and the most notable is that imputed interest rules do not apply to loans of less than $10,000 - as long as the loan is not used to buy income-producing assets.

Let's examine another possible business deal among family members. You decide to sell Junior your beach house. It doesn't qualify as your primary residence, so there will be income tax due on the sale - a lot of income tax.

You've heard about a technique called an installment sale, and you decide you will sell the house to Junior that way. In an installment sale, Junior pays you back over time, and you only pay taxes on the prorated capital gains each year. Great deal, right? 

It should be, but it might not be. If Junior sells the property prior to owning it for two years, you must report and pay taxes on the entire remaining capital gains on the property the year of the sale. That is true regardless of when Junior pays you back.

This article first appeared in Military Officer, February 2018.

Curt Sheldon, CFP®, EA, is a retired Air Force officer and fighter pilot. He is the author of Well and Faithfully Discharged:  Financial TTP for Military Retirement (CreateSpace, 2017). His last feature article for Military Officer was “Tax Traps,” February 2017.