Loan guarantees can cause tax problems

Nation's Business, Oct, 1991 by Albert B. Ellentuck

In difficult economic times, many parents guarantee loans to their children to help them obtain financing for a business or for personal reasons. Parents know they face a risk if the child defaults, and they also realize they probably won't get the money back from their child.

In addition, a parent who must make payments on the guaranty is not likely to make a good-faith effort to collect from the child, and thus the payment could be considered a gift subject to a gift tax.

Few parents believe that the mere act of signing the guaranty could itself cause problems. Yet in a private ruling, the Internal Revenue Service held that the guaranty itself can be considered a taxable gift. In this case, the co-signer's guaranty allowed his son to obtain a loan with a below-average interest rate. Accordingly, the IRS said the guaranty was a transfer of something of value and therefore was subject to a gift tax.

The ruling did not explain how to value the gift, although one logical way is to calculate the present value of the interest rate differential between the loan actually obtained and the loan that could have been obtained without the guaranty.

This ruling may not be as serious as it sounds, however. As an example, by guaranteeing a car loan, a father helps his daughter get a loan with a 10 percent interest rate rather than the 11 percent rate she could have obtained without his guaranty. For a four-year $15,000 loan, the present value of the interest rate differential of 1 percent would be about $500, well under the $10,000 annual gift exclusion.

But consider a father's guaranty of a mortgage on a home purchase by his son for $270,000, with a 30-year mortgage for $200,000 and an interest rate differential of 2 percent. In this case, the present value of the gift would be about $38,000, well above the $10,000 annual exclusion, or above even the $20,000 exclusion available if the spouse joins in the gift.

Although this private ruling for one taxpayer who requested it has not been reviewed sufficinetly to be considered an official IRS position, it does indicate IRS thinking on this issue.

Thus, if there is a substantial loan guaranteed, it may be wise to take some preventive measures. If the amount you calculate as a "gift" exceeds your $10,000 annual exclusion, consider filing a gift-tax return and have your spouse join in that return in order to consent to the gift. In this way, you would have a $20,000 annual exclusion applicable to the "gift."

If the gift runs over the $20,000 annual exclusion, you might want to consider borrowing the money from the bank yourself and lending it to your child directly. As long as the loan is at the standard IRS interest rates, there should be no gift-tax consequences at the time of the loan. However, this may be impractical on the purchase of a home. In addition, the borrower may not be able to deduct the loan's interest payments since the interest would be considered personal.

The ruling is likely to cause considerable adverse comment from taxpayers, and the IRS may well reconsider it.

Tax Lawyer Albert B. Ellentuck is a partner in the Washington law firm of Colton and Boykin. Readers should see tax and legal advisers on specific cases.