Does your adult child need money to buy a new home or start a business venture? You may offer to help them out with a low-interest or no-interest loan.

Strategy: Be careful to stay within the tax law boundaries. If you don’t, you could be blindsided by an unexpected tax bill.

Here’s the whole story: The tax law discourages intra-family loans where you don’t charge any interest or you charge interest at a below-market rate. Briefly stated, imaginary interest income may be imputed to the lender under the following sequence:

• You’re treated as having made a gift of imaginary interest—that is, the imputed interest— to the borrower.

• The borrower is treated as having used the gift to pay the imputed interest to you.

• You must report the imputed interest as income on your tax return. In other words, you’re hit with a tax bill on this imputed interest income, even though you never receive a plugged nickel in actual interest. Tax practitioners often call this “phantom income.” Fortunately, there are two possible ways you may be to able avoid a dire tax result.

1. Lend the family member less than $10,000. There’s a “de minimis exception” in the law for loans totaling $10,000 or less if the loan is not directly attributable to the purchase or carrying of income-producing assets. For example, if you lend your son or daughter $9,500 to pay some of their bills, the imputed interest rules don’t apply.

2. Lend the family member less than $100,000. For loans totaling $100,000 or less, the amount of imputed interest you’re treated as receiving for tax purposes is limited to the borrower’s net investment income for the year. If the borrower’s net investment income doesn’t exceed $1,000, there’s no taxable imputed interest income.

Note: This special exception does not apply if you charge a below-market interest rate for tax avoidance purposes. The IRS can be especially tough on loans reputedly made for business purposes. If you can’t present clear and convincing evidence that the loan is tied to a business transaction, it may be deemed to be a gift. For instance, you can’t just lend your child money to buy business supplies without any documentation. In that case, you’re not entitled to any tax benefits if the loan isn’t repaid. Practical idea: Instead of giving your child a no-interest loan above $10,000, you might charge the child interest equal to the Applicable Federal Rate (AFR) for the month of the loan. The AFR rates have been relatively stable since the start of 2024, but of course, that could change (see box for the annual rates for August 2024). Also, spell out in writing the key elements of the loan agreement, including the amount, the time for repayment and the designation of collateral. Finally, have the loan document witnessed and notarized. This way, you’ll have proof on your side if the IRS ever challenges the transaction. If your child can’t repay a legitimate loan, your loss is treated as a short-term capital loss when the loan becomes worthless (i.e., there’s no reasonable prospect for repayment). Therefore, you can use this loss to offset capital gains realized during the year, plus up to $3,000 of ordinary income.

Tip: For a loan that qualifies as a legitimate business loan, the full amount of the loss may be deductible against highly taxed ordinary income (e.g., salary).