Some “sweetheart loans” look like an entirely normal, commercially reasonable transaction – however, the lender (mom and dad, for example) never actually collects the debt service (interest and perhaps some portion of the principal) from the borrower (daughter and son-in-law, for example). When the monthly, or more likely, yearly debt service comes due the payment is forgiven; it becomes a gift. When this process is integrated into some simple tax planning, like use of the annual gift tax exclusion, it can become a useful device for transferring wealth without incurring gift tax. Once caveat to this: if the IRS takes the position that you had no intention to collect the debt payments at the outset, the “lender” presumably risks having the whole loan treated as a gift in the year the “loan” is made.
Additionally, cancelling debt service is an all or nothing approach. It certainly has no application in the case of a commercial transaction, where a seller wants simply to make the transaction happen, or in a family loan situation where the lender wants to give the borrower a break but is unable, or unwilling, to give up all rights to repayment. Thus a far more common approach, at least in these scenarios, is to give a no-interest loan or a below market interest loan.
A no-interest loan sounds simple enough; the lender writes a check for a certain sum of money and then expects that the sum of money (and only that sum of money) to be paid back over time. In the lender’s mind, it is all principal when it is loaned, and it is all principal when it is re-paid.
Such “interest free” loans often pose complicated questions involving timing, “original issue discount,” and even picking the correct applicable federal rate and compounding period. Finally, different loans get different treatment. Larger loans are often treated differently from smaller loans, and some interest free loans are altogether exempt from IRS re-characterization. In summary, tax treatment of interest free loans can be quite complex, and the conclusions can be quite surprising. It would be advisable to at least run through the basics of it with your tax advisor before making such a loan.
— Rod Fluck