Riba is Haram, but is Interest?
One of the more confusing aspects to Muslims is “riba” which is often (maybe imprecisely) translated as “interest.” It is a grave issue. In the Quran, Surah Baqarah, it says the following:
O believers! Fear Allah, and give up outstanding interest if you are ˹true˺ believers.
If you do not, then beware of a war with Allah and His Messenger! But if you repent, you may retain your principal—neither inflicting nor suffering harm.
Here you will notice “riba” is translated as “Interest.” The translator is Dr. Mustafa Khattab. Other translators, such as Mufti Taqi Usmani, do not translate “riba” at all, but leave the transliterated Arabic word in the translation. Abdullah Yusuf Ali uses the term “usury.” From my understanding of how finance works in the real world, the word “interest” is imprecise. A fulsome discussion of riba is outside the scope of this article, since I want to keep to the Muslim gift and estate tax planning context.
Muslims want to make sure we avoid riba. We should also want to do our Islamic Estate Planning. However, “interest” is often an unavoidable feature in estate planning, and in particular Gift and Estate Tax Planning. That does not need to mean riba.
A Story of Interest When There is No Riba
Haroon, 65, has an import-export business worth $2,000,000 based on an appraised value. He wants his son Elyas to have the business and supplement his retirement while being fair to his children by not just giving away something to one son that he will not give away to his other children. Haroon gets a fair price for his business and in his Islamic Estate Plan, he would distribute his estate based on the Islamic inheritance rules after he passes away. The business will not be in his estate anymore since he sold it.
Haroon sells the business to his son Elyas for $2,000,000, payable over 20 years with zero interest. Simple right?
Imputed Interest
The IRS, because of Section 7872 of the Internal Revenue Code is going to apply “imputed interest,”- which is to say the law understands the economic consequences of a free loan. We get to what the loan looks like by calculating something called an “original issue discount.” In addition, this is going to be a “gift,” which may have its own tax consequences. In federal tax, the estate and gift tax system is somewhat distinct from the income tax system, though there is crossover.
So, in this example, with Haroon and Elyas, the “interest free loan” will not be regarded this way. It would be a “partial gift” and “partial sale.” That means he is not really selling his business for $2,000,000. He is selling it for $796,648.61. This is the original issue discount (at the time of writing since this will vary).
You get this by applying the “Applicable Federal Rate” (AFR), which changes every month. The rest of it, $1,203,351.39, is a gift. In the open market, if we had an “arms-length transaction” with an unrelated party- Haroon would never actually sell his business for two million unless it was cash up front. He would be assuming the risk of default and losing out on having the ability to deploy the cash for other purposes. Also, the value of $2,000,000 for the business assumes cash right now, not a 20-year loan.
Original Issue Discounts or Even “Interest” is Permissible Here
Now in Islam, it is considered permissible for Haroon to sell the $2 million business for $3.2 million or even $4 million. This would be a cost-plus contract, effectively getting an interest rate that would be reported as interest income on Haroon’s tax forms. That is not riba, but rather a “murabaha” contract since it is not money for money, but a thing being sold on a payment plan. It has long been understood that trade is permissible, but riba is not. Selling something for more money over time than the cash price is often a fair deal.
Gifts and “Fairness” within the family
Intra-family loans are common in families. In my example, it was the sale of a family business. The older generation may also use loans to sell properties to their children. They may not give it away because if they have three or five children, they may not have three or five homes of the same value to give away. There is frequently a misunderstanding between children and parents about what is a “gift” and what is a “loan.” Both have tax implications, but more importantly, they have family harmony consequences as well.
De Minimis Exception: No Interest, No Riba
We do not worry about loans of a small value. Under the Internal Revenue Code, this is a loan of $10,000 or less. This can be safely given interest free. However, the parties should still write these loans down. So, a father loaning his son, who was recently laid off, $10,000 interest-free to help pay some expenses is usually not going to cause problems.
Loans Used in Estate Planning
Notes with interest are a common way to conduct estate planning, especially for those with higher net worths or complex assets. All of what an Islamic Estate Planning Attorney does when doing Estate and Gift Tax Planning can effectively be described as using the exemptions that exist in the tax code, combined with the time value of money. As a result, gifts and sales with interest are common. In Islamic Estate Planning it is vital that when these arrangements are created, they are done in a way that will match your values and not result in injustice or oppression.
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