Advice On Family Loan (IRS)

1. Is It a Loan or a Gift?

Why It Matters: For loans over $10,000, the IRS generally requires you to pay at least the Applicable Federal Rate (AFR) of interest; otherwise, it may impute interest (i.e., treat part of it as “gifted”).
Short-Term Loan Exception? There is no broad exception simply because the loan is very short-term. While it’s unlikely the IRS will heavily scrutinize a short-term loan among family, it’s still prudent to follow best practices—especially given the loan is $40,000, which is well above the annual gift tax exclusion amount ($17,000 for 2024).

2. Should You Document the Loan?

Yes. Even for a very short-term loan, documentation helps establish that this is truly a loan (not a disguised gift) if the IRS inquires.
Elements of a Simple Loan Agreement:
1. Principal Amount: $40,000.
2. Date of the Loan: December 30, 2024.
3. Repayment Due Date: January 4, 2025.
4. Interest Rate: At or above the short-term AFR for December 2024 (or January 2025, depending on timing)—this rate is usually quite low.
5. Signatures & Date: Both you and your family member sign and date the document.

This documentation protects both parties if there’s ever a question about the nature of this transfer of funds.

3. Do You Need to Charge Interest?

IRS Imputed Interest Rules: If you do not charge interest on a loan larger than $10,000, the IRS may “impute” interest. This means the IRS pretends interest was charged at the AFR and counts it as income to the lender (and potentially a gift from the lender to you).
Short-Term AFR: For loans under three years, the short-term AFR applies. It is usually quite low (often well under 2% or 3% annually in recent history). On a 5-day loan, the actual dollar amount of interest would be minimal—but documenting the interest rate helps keep you in the clear.

Example

If the short-term AFR is 5% per year (just as a round number example), the interest on $40,000 over 5 days might be around:

$40,000×0.05×5/365≈$27

While $27 might seem negligible, formally including it in your loan agreement is what keeps the transaction compliant.

4. Tax Consequences to Consider

For You (the Borrower):
- Borrowed money is not considered income, so it will not increase your 2024 income.
- If the IRS viewed part of the transaction as a gift due to no/low interest, that would not affect your personal taxes directly but could affect the lender.
For Your Family Member (the Lender):
- If no interest is charged and the IRS determines the difference between the AFR and zero interest is a gift, they might have to file a Form 709 (Gift Tax Return) if it exceeds the annual gift tax exclusion ($17,000 in 2024).
- If you pay interest, the lender should report that interest income on their tax return, but that also means it’s less likely to be reclassified as a gift.

5. Practical Tips & Next Steps

Create a Simple Loan Agreement: Include principal, date, due date, interest rate (at least AFR), and signatures.
Calculate a Minimal Interest Amount: You can use the short-term AFR to find a nominal but IRS-compliant interest charge.
Keep Good Records: When you repay the loan on January 4th, 2025, keep proof (bank statements or canceled checks) in case you need to demonstrate the money movement.
Consult a Professional (Recommended): Even though it’s a short-term loan, if you want complete peace of mind, consider a quick consultation with a CPA or tax lawyer who can confirm your documentation and interest setup.

Bottom Line

Yes, it’s advisable to document the loan in writing (family loans over $10,000 typically should be formalized).
Yes, to be fully IRS-compliant, it’s best to charge at least the short-term AFR. The interest you’ll pay over 5 days is minimal, but it avoids any gift tax complications for your family member.

By following these guidelines, you’ll help ensure that the $40,000 transfer is recognized as a legitimate short-term loan instead of a gift, which could have tax ramifications for your family member.