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You could face tax problems when you lend money, as you’re being repaid, and/or if you’re not repaid. These problems are normally imputed income, gift tax, or bad debts:

Imputed income: revenue presumed earned but neither recognized nor received by alleged recipient. The IRS may impute interest on a loan at the “applicable federal rate” (AFR) when a lower rate or no interest is charged. The agency will assess tax on the excess of the imputed interest over amount required by terms of the loan.

Gift tax: When the IRS imputes phantom interest, it also creates phantom taxable gifts. The imputed interest is treated as though the borrower actually paid it to their lender. Since the lender “constructively received” the additional interest, they owe income tax on it & also owes gift tax, unless an exclusion or credit applies.

Bad debts: Normally a loan that goes bad is deductible either against ordinary income or as short-term capital loss. The IRS may demand clear & convincing evidence that the original loan was not actually a gift. Once a loan is characterized as a gift, no bad debt deduction will be allowed if the loan isn’t repaid. The lender may also owe gift tax on the principle unless an exclusion or credit applies.

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