Overview

Main Menu Name: Gift Loans

The program will calculate the present gift that is made by making a "below-market loan" with an interest rate that is less than the applicable federal rate, and the foregone interest that is imputed to the lender in the future.

In this article:

• Background
• Getting Started
• Entering Data
• Results

Background

Under section 7872 of the Internal Revenue Code, a loan can result in an immediate gift if (a) the loan is for a fixed term (and not payable on demand), (b) the loan is a "below-market loan" because the interest rate is less than the applicable federal rate (defined by section 1274(d) of the Internal Revenue Code), and (c) the foregone interest (the difference between the rate of interest charged on the loan and the applicable federal rate) is in the nature of a gift.

For a gift loan, the amount of the gift is the difference between (a) the amount received by the borrower and (b) the present value of all future payments to be made, based on the applicable federal rate in effect at the time the loan is made.

For income tax purposes, each year's foregone interest is treated as received by the lender on the last day of the calendar year.

Given the amount of the loan, the term of the loan, the frequency of the payments (monthly, quarterly, semiannually, or annually), whether the loan is amortized, level principal, or interest-only, the interest rate for the loan, and the applicable federal rate, the future payments can be calculated, along with the present value of those payments, the amount of the gift, and the future amounts of foregone interest.

In an amortized loan, the payments are calculated so that the periodic payments of combined interest and principal are equal amounts over the term of the loan. The interest is always calculated on the principal balance owed, but the interest amount goes down (and the principal amount goes up) as the principal of the loan is paid. So, early in the loan, the payments will be mostly income with very little principal paid, while towards the end of the loan the payments will be mostly principal with very little interest payable on the declining loan balance.

In a level-principal loan, the principal payment is fixed as the amount needed to pay off the principal amount over the stated term, and if there is no "balloon" payment, then the principal portion of each loan payment will be the principal amount of the loan divided by the number of payments to be made. The interest portion of each payment is calculated on the principal balance remaining, so the interest amount goes down as the principal of the loan is paid. Because the principal portion of each payment is a fixed amount, and the interest portion goes down over the course of the loan, each loan payment will be different, and the payments will go down over the term of the loan.

In an interest-only loan, no principal is paid until the end of the term. Because the principal of the loan remains the same throughout the term, the interest payments also remain the same.

A compromise between an interest-only loan and an amortized or level-principal loan is a loan in which some principal is paid during the term and the balance is paid as a "balloon" at the end of the term. So, for example, the periodic payments on a loan can be calculated based on an amortization over 30 years even though the term of the loan is only 15 years, in which case the balance of the principal is payable as a lump sum "balloon" at the end of the 15 years. A level-principal loan can also be calculated with a principal-recovery period that is longer than the actual term of the loan, also resulting in a balloon payment at the end of the term.

The "annual percentage rate" or "APR" is a useful number to know in comparing the true costs of different kinds of loans, and the APR is not necessarily the same as the interest rate used to calculate the loan payments. If the payments are monthly, quarterly, or semiannual, the APR will not be the same as the interest rate that is entered for the note because payments that are more frequent than annual have the effect of compounding the interest rate, so the APR (or effective interest rate) is higher.

The present value of future loan payments is calculated by discounting the future payments back to present value by applying the applicable federal rate.

The foregone interest is the difference between the interest actually payable under the loan and the interest that would have been payable using the applicable federal rate.

Getting Started

Under section 7872 of the Internal Revenue Code, a loan can result in an immediate gift if (a) the loan is for a fixed term (and not payable on demand), (b) the loan is a "below-market loan" because the interest rate is less than the applicable federal rate (defined by section 1274(d) of the Internal Revenue Code), and (c) the foregone interest (the difference between the rate of interest charged on the loan and the applicable federal rate) is in the nature of a gift.

For a gift loan, the amount of the gift is the difference between (a) the amount received by the borrower and (b)the present value of all future payments to be made, based on the applicable federal rate in effect at the time the loan is made.

For income tax purposes, each year's foregone interest is treated as received by the lender on the last day of the calendar year.

Given the amount of the loan, the term of the loan, the frequency of the payments (monthly, quarterly, semiannually, or annually), whether the loan is amortized, level principal, or interest-only, the interest rate for the loan, and the applicable federal rate, the future payments can be calculated, along with the present value of those payments, the amount of the gift, and the future amounts of foregone interest.

Entering Data

1.  Principal of Note:  Enter the amount of money borrowed or credit extended (in the case of an installment sale).
2.  Interest Rate on Note:  Enter the annual rate of interest on the loan.
3.  Term of Note:  Enter the term of years for the loan.
4.  Type of Note:  Select from amortized (in which each payment is the same), level-principal (in which the principal portion of each payment is a fixed amount but the interest portion changes as the principal is paid), or interest-only (in which fixed amounts of interest are paid but no principal is paid until the end of the term of the note).
5.  Payment Period:  Select from Monthly, Quarterly, Semiannual, or Annual.
6.  Balloon Payment:  Check this box if the amortization or level-principal payments should be calculated using a number of years greater than the term of the loan, so that there is a principal "balloon" payment at the end of the term.
7.  Amortization or Principal-Recovery Period:  If "Balloon Payment" is checked, enter the number of years to be used to calculate the amortized or level-principal payments.
8.  Applicable Federal Rate:  Depending on the payment frequency, enter either the annual, semi-annual, quarterly, or monthly applicable federal rate for the month in which the sale occurs. The applicable federal rate for a loan with a weighted average maturity of not more than three years will be the federal short-term rate, the applicable federal rate for a loan with a weighted average maturity of more than three years but not more than nine years will be the federal mid-term rate, and the applicable federal rate for a loan with a weighted average maturity of more than nine years will be the federal long-term rate. Current and historical AFRs can be found through our web pages, at http://www.brentmark.com.

Results

On the Summary tab, the program will show the present value of the future loan payments, which is calculated by taking the amount of each future payment, whether principal or interest, and discounting that payment back to present value using the applicable federal rate. The amount of the gift is the difference (if any) between that present value and the principal of the note.

On the Schedule tab, the program will also show the amount of each periodic payment, the interest and principal included in each payment, the present value of each payment, and the foregone interest for each payment, as well as the totals of interest paid, principal paid, present values, and foregone interest.

The results of the calculations are shown as a chart with columns and rows, each row representing one periodic payment on the loan.

The present value of each payment is the total payment (both principal and interest) discounted back to present value using the applicable federal rate, compounded by the payment periods.

The foregone interest is the difference between the applicable federal rate times the principal balance and the interest actually payable.

In the header of the column showing the interest payments, the program also shows the annual percentage rate or APR that the interest payments represent. If the payments are monthly, quarterly, or semiannual, the APR will not be the same as the interest rate that is entered for the note because payments that are more frequent than annual have the effect of compounding the interest rate, so the APR (or effective interest rate) is higher. (The APR is for informational purposes only, and does not affect the gift tax or income tax consequences.)