A tax law introduced in 1986 tax rules that when a parent makes an interest free loan to a child, the parent will be treated as receiving interest income equal to the federal interest rate on short term obligations. The child is to be treated as having an interest expense and is subject to the limitations on interest deductions. However, if the child is in a zero tax bracket, it doesn't matter if there isn’t any deduction allowed for the interest expense.

The object of this law is to put both parent and child in the same economic position they would have been in if the loan hadn’t been made. Additionally, the amount of interest would be treated as a gift from the parent to the child, which would use up part of the annual gift exemption..

However, there are two exceptions to these rules:

A. If the loan is less than $10,000 any time during the year and should the money not be used to earn investment income, the end result shall be treated as a “de minimus” exception. In order to qualify, it’s necessary to show the money is not being used in purchasing income producing investments. However, the loan could be used to purchase non-income producing investments.

B. This is when a gift loan is made between individuals for less than $100,000. The amount of the interest to the lender, (i.e., the parent) is limited to the amount of the investment income earned by the borrower (i.e., the child). Furthermore, should the net investment income of the borrower be less than $1,000 a year, then the net investment income is treated as if it were zero. Once again, should the money be used to purchase growth assets, such as land, collectibles or certain stocks, there is no investment income and is no interest income given to the parent. But, there catch in overcoming this exception, which is that the exception is not available if the purposes of the loan is tax avoidance.

Additionally, should the child be less than 14 years of age, any of the child’s investment that is more then $1,500 per year will be taxed at the top rate of the parents. To simplify tax preparation, the parents could choose in having the child's investment income of more than $1500 included in their tax return by using tax form 8615.

For dependent children under the age of 14, the first $750 of investment income is subject to a zero tax rate, while the next $750 of investment income is subject ten percent tax rate. With low yields available on investments in early 2003, a child would need about $50,000 to earn $1,500 a year of investment income. If it’s interest income, the parent would be paying 35% for federal taxes, plus state income taxes. The savings in federal taxes could be $450 per year for each child under the age of 14.

If the child is over the age of 13, there are other ways to save on taxes. If the child can invest the money at a rate greater than the short term federal rate, there is an advantage in making such loans. For instance, if the short term federal rate is 3% and child invests the money in tax lien certificates at 12%, there is a net spread of 9%. With a loan of $100,000, the child makes $9000 a year, subject to tax at a 10% rate. But, the parent of the child would lose the personal exemption of $3050, which is worth up to $1,067 in federal taxes.

Therefore, this loan arrangement is worth a tax savings of nearly $3,950 a year.
Another variation of the reverse interest free loan is to making an irrevocable gift of money to a child and to borrow the money back later, and at the highest prevailing interest rate. If the use of the borrowed funds is for a deductible purpose, then the interest should be deductible. There could be a potential problem in the legal capacity of a minor child entering into loan transactions, so its necessary for the one parent to act on behalf of the child. That can be done with a simple revocable trust where the other parent is the trustee.

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