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Tax Implications of an Interest Free Loan

 

Interest Free Loan

What are the tax implications of making a big interest free loan to a family member, say for a house? Your intention may be to spare them the burden of paying interest on a big bond.

But, is there a legal document you are required to take out? And how will the South African Revenue Service (SARS) react to a big drop in your income after making the loan?

We call this planned transaction an interest free loan. A typical loan is money lent to be paid back in full, or in instalments at certain set dates. Typically, the lender specifies an interest rate also to be paid. But, with an interest free loan, naturally, the borrower pays no interest.

 

Long-term Impact

As a rule, you should not make an interest free loan to anyone, family or otherwise, if it puts your own financial health at risk. Retirees should be especially careful in this sense.

Always consider the long-term impact that making an interest free loan could have on your retirement fund, funeral cover or life insurance. Think about how many years it will take for the family member to pay it back.

 

Formal Agreement

Although you are dealing with a family member, for the arrangement to be successful, it’s advisable to set up a formal interest free loan agreement. This document will formally recognise the outstanding debt. Also ensure the family member understands and formally agrees to their obligations.

This can be done most effectively with the assistance of an attorney. Make sure the contract factors in what will happen should the debt not be repaid or one of you pass away.

An interest free loan agreement is essential for ensuring that the planned transaction is not mistaken for a donation. A donation attracts a tax rate of 20%. A formal contract would explain the abrupt fall in invest capital, if SARS were to question it.

 

Estate Planning

What you should also know is that the outstanding interest free loan would stay an asset in your hands, even if you were to pass away. In such a case, the interest free loan would normally be recognised as an estate asset. This would mean it would attract estate duty, currently at 20% of the dutiable sum.

Obtaining the assistance of a financial planner to set up the planned transaction would be highly advantageous. This way, you could attend to the necessary estate planning. You may need to take capital gains tax into account too. If you are selling an investment to provide the loan capital.

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