Tax tip: Be careful with private loans

It is not uncommon for people to borrow large sums of money from family members or friends. However, many people do not realise that this can incur considerable taxes. This applies both in the event that no interest or interest rates that are too low compared to the market level are agreed for the loan.

This was decided by the Federal Fiscal Court and the reasoning has just been published (judgement of 31 July 2024 - II R 20/22). According to this judgement, the granting of a non-market interest-bearing loan is taxable as a gift.

In this particular case, the father had bequeathed an agricultural farm to his son. The daughter then demanded her compulsory portion of 1.8 million euros from the brother. As he was unable to raise this, he agreed a loan with the sister with an interest rate of one per cent and an unlimited term. The tax office considered the difference between the statutory interest rate of 5.5 per cent and the agreed interest rate of one per cent to be a gift and assessed a gift tax of EUR 229,500. The statutory term for loans with an unlimited term of slightly less than 13 years was used as the term. The taxpayer unsuccessfully appealed to the Mecklenburg-Vorpommern Fiscal Court and lodged an appeal with the Federal Fiscal Court.

Not unexpectedly, the Federal Fiscal Court confirmed that the waiver of standard market interest rates constitutes a gift. However, a lower market interest rate of 2.81% was used in the proceedings - to the taxpayer's advantage - based on data from the Deutsche Bundesbank for comparable loans with a term of 5 years, as the contract provided for a first cancellation option after 5 years.

The gift is recognised at the time the loan is paid out. This means that not only the difference is recognised as a gift each year, but the entire interest advantage achieved over the term of the loan is calculated down to the date the loan is granted, resulting in high gift values right from the start.

In the judgement case, the annual interest advantage was calculated as the difference between the standard market interest rate of 2.81% and the agreed interest rate of 1% and therefore amounted to 1.81%. For the loan of 1.8 million euros, this resulted in an annual advantage of around 34,000 euros. Taking the term into account, this adds up to a gift amount of 315,700 euros. As there is only a tax-free allowance of 20,000 euros between siblings, the taxable gift therefore totalled 295,700 euros. At a tax rate of 20 per cent, this resulted in a gift tax of 59,140 euros. Compared to the gift tax of 229,500 euros assessed by the tax office, this represents a pleasing reduction of 170,300 euros.

In order to avoid unexpected tax burdens, existing loan agreements in the private sphere should be checked for comparability with third-party loans and adjusted if necessary. When granting private loans, it is crucial to keep an eye not only on the interpersonal aspects but also on the tax consequences.

The author is a tax consultant at KPMG.