Our church board has approved a $10,000 no-interest loan to one of our pastors to assist him with the down payment on a new home. We have two questions about this transaction. Since the loan is for $10,000, it is our understanding that the foregone interest would not represent taxable income to him. Is this correct?
Second, if we decide to forgive the loan, we understand that the balance will be considered income and subject to federal and state income tax. At the time of forgiveness, does the entire balance become taxable or is it taxable incrementally throughout the remaining duration of the loan?
Let me make a few observations in response to your questions.
First, if the church makes a below-market interest loan of more than $10,000 to an employee, it would have to report the "foregone interest" as taxable income to the employee.
Second, employers that make below-market interest loans of $10,000 or less to an employee are not required to report the foregone interest as taxable income, but only to the extent that a principal purpose of the transaction was not the avoidance of tax. To the extent that the church fixed the amount of the loan as $10,000 for the express purpose of avoiding the realization of taxable income, then the exemption may be lost.