Interest Free Loans to Nonprofits – not so simple

Has your nonprofit tried encouraging donors to make interest free loans to your organization?

A friend asked me yesterday to assist him in making of a $400,000 interest free loan to a charity.  Sounds simple.  Think again.

I mentioned a strange rule – that I had looked up a year or two ago – that making  over $250,000 in interest-free loans in a tax year could subject the donor/lender to imputed interest (i.e. the IRS would tax the DONOR/LENDER as if he/she received taxable interest payments from the nonprofit).

He, being a former tax attorney himself, shook off the suggestion; it must be the recipient as the one who gets the imputed tax – as the organization is receiving a benefit each year of not paying the interest. And, nonprofit organizations are tax exempt – end of story.

Think again.

The IRS code section is 7872 and it is in the regulations on that section.   This section is actually about imputing taxable income on lenders of lower than market value loans, not about nonprofits.  The rule basically says you have to report as income (phantom income) the total interest payments you should have been receiving.

What about loans to nonprofits?  Under the general rule (wait for the exemption!), the lender of a tax-free or below market rate loan is considered as if he received total interest payments at the prevailing rates.

So, the donor of a so-called interest free loan, even to a charity, is supposed to pay taxes on phantom income on whatever the imputed interest was supposed to be.  Then, if it was to a nonprofit, the donor gets credit for a charitable gift of the amount he was supposed to receive.

In other words, $10 of taxable income, $10 of charitable deduction.

The exception: individuals can make up to $250,000 in interest-free loans to nonprofits (qualified 501(c)(3)s) each calendar year without the above applying (no phantom interest but also no charitable deduction for value of the “gift” of the interest from the tax-free loan).

Sounds silly.  What is the difference?

Well, if your donor uses up his maximum deductions (50%/30% ceilings), then it might be a problem.  He will have the income but not be able to take some or all of the deduction this year.  Also, higher AGIs have some loss of deductions.  So, it is a cleaner transaction from a tax perspective if the donor/lender stays below $250,000.

Now my friend’s situation.  The organization asking for the tax-free loan is planning on buying a property and will place a mortgage on it (albeit interest free) setting up the donor/lender as the first lien holder on the property securing the debt.

Problem I am working out is that my friend actually may exceed the so-called 50%/30% ceilings and/or run into some deduction reductions at higher AGI levels.

How do we structure this gift of a short term, interest-free loan so that it doesn’t cost the donor/lender in phantom taxes not offset by imputed gifts each of the interest he could have received?

I am not sure where this one will go.  Next hopefully will be a discussion of these issues with his accountant, and then the nonprofit.  Maybe we structure $250,000 as an interest-free loan and $150,000 as a donor advised fund gift?  Obviously, the donor advised portion doesn’t go back to the donor – it will eventually be sent to nonprofits (which could include that same nonprofit or not).

To be continued….

6 comments

  1. Typical – we (the donor and myself) were given about two minutes to liquidate stock to fund the interest free loan.

    So, we will have to deal with the tax consequences of making an interest free loan over the $250,000 threshold at tax time next year. I suspect it will be an annoyance of a few thousand in extra taxes to be paid. At least I warned the parties and told them to work with the donor’s personal accountant.

    1. As far as I know, YES. It is not such a problem – especially since currently the imputed income is offset by the charitable deduction. The key is that the donor’s accountant knows about it and knows how to handle it and that you give an appropriate tax receipt at the end of each year for the value of the interest not charged.

    1. Almost missed this one. Anyone making a loan that bears interest pays income tax on the interest. Interest free means no income tax to lender (as long as you stay within the annual limit of up to $250,000 to a charity. IRS Reg. 1.7872-5T(b)(9)). Above that $250,000 level, the IRS will impute interest income to the donor and make him/her pay tax on phantom interest.

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