What Is It Called When Your Parents Give You Money?
Demystify the financial and tax implications of money transfers from parents to children, and how they are officially classified.
Parents often provide financial support to their children for daily needs, education, or significant milestones like purchasing a home. The way this money is transferred impacts its financial and tax classification. Understanding these distinctions is important for both parents providing funds and children receiving them, as different classifications carry varied implications. These transfers are not always simple gifts and can be categorized in several distinct ways.
Understanding Financial Gifts
The Internal Revenue Service (IRS) considers a gift to be any transfer of money or property to an individual where nothing of equal value is received in return. Under federal tax law, the responsibility for any potential gift tax typically falls on the donor, the parent in this scenario, not the child receiving the funds.
The annual gift tax exclusion permits individuals to give a certain amount to another person each year without triggering gift tax or requiring a gift tax return. For 2024, this annual exclusion amount is $18,000 per recipient. If two parents jointly give, they can collectively transfer $36,000 to each child annually under this exclusion.
When a gift exceeds the annual exclusion amount, the donor is required to report the transfer to the IRS. For instance, if a parent gives a child $25,000 in 2024, the $7,000 exceeding the $18,000 exclusion must be reported. Although reporting is necessary, it does not automatically mean gift tax is immediately due. Each individual also has a lifetime gift tax exemption, a cumulative amount that can be given away over a lifetime without incurring gift tax.
For 2024, the lifetime gift tax exemption is $13.61 million per individual. Any amount exceeding the annual exclusion reduces the donor’s lifetime exemption. Gift tax only becomes payable if the total amount of taxable gifts made over a lifetime surpasses this exemption. To report gifts exceeding the annual exclusion, the donor must file IRS Form 709. This form tracks the portion of the lifetime exemption used, even if no tax is owed.
Distinguishing Loans from Gifts
The difference between a loan and a gift lies in the expectation of repayment. A gift is a transfer with no expectation of being returned, whereas a loan implies a clear agreement for repayment. Without proper documentation, the IRS may reclassify an intended loan as a gift, which can lead to unintended tax consequences. To establish a transaction as a loan, especially between family members, formal documentation is important.
This documentation includes a signed promissory note detailing the loan amount, interest rate, repayment schedule, and maturity date. Clear terms demonstrate the intent for repayment. Loans between family members are subject to IRS rules concerning interest rates, known as Applicable Federal Rates (AFRs). The IRS publishes these minimum interest rates monthly, categorized by the loan’s term: short-term (up to three years), mid-term (three to nine years), and long-term (over nine years).
If a family loan is made interest-free or at an interest rate below the applicable AFR, the IRS may “impute” interest. This means the difference between the AFR and any interest charged can be treated as a taxable gift from the parent (lender) to the child (borrower). This imputed interest can also be considered taxable income to the parent, even if no cash interest was received. For a properly structured loan, the principal repayments are not taxable income to the parent, but any interest received by the parent is considered taxable income.
For the child, the loan principal received is not taxable income. However, if a loan is later forgiven, the forgiven amount is reclassified as a gift and subject to the gift tax rules for the parent. To avoid a loan being reclassified as a gift, it is important to treat the transaction formally. This includes maintaining a written loan agreement, adhering to the repayment schedule, and charging at least the minimum AFR interest rate. Consistent repayment confirms the transaction’s intent as a loan.
Support Payments and Other Transfers
Beyond gifts and loans, parents may provide financial assistance through other classifications, each with distinct tax treatments. Money provided for the support of a child who qualifies as a dependent is not subject to gift tax. This applies to funds used for basic living expenses, education, or medical care for children who meet dependency criteria, such as being under 18 or a full-time student under 24. These support payments are neither taxable income for the child nor subject to gift tax for the parent.
If a child performs legitimate services for a parent’s business or personal needs and receives compensation, this payment is considered taxable income to the child. Such payments are distinct from gifts because they represent earned income for work performed. The child reports this income on their individual tax return, similar to other employment earnings.
Funds or assets received by a child after a parent’s passing are classified as an inheritance or bequest. These transfers fall under estate tax laws, which operate separately from gift tax rules. While large estates may be subject to federal estate tax, the recipient of an inheritance does not pay federal income tax on the inherited amount. This differs from financial transfers made while parents are alive, as inheritances are a post-mortem distribution of assets.