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IRS stops family 'loans' for college

I've heard of several people helping to pay for their children's college education by lending their child the money which the parents then borrowed back, using their house as collateral. I'm considering this step for our children. Could you explain how it works? D.C.

It doesn't work anymore. The Internal Revenue Service recently issued a ruling that prevents parents from claiming a tax deduction on situations like this.

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As explained by the Seidman & Seidman accounting firm, the parents in the case lent their child $50,000, which was backed by the child's non-interest-bearing demand note. A few days later the child returned the money to the parents in exchange for a 20-year, 17 percent note secured by a mortgage on the family home. The student was then able to use the loan payments for college tuition and expenses. The parents claimed the interest payments on their (higher tax bracket) return, and the child included the interest income on his (much lower bracket) return.

But the IRS ruled there was no ''debtor-creditor relationship,'' since the circular flow of $50,000 did nothing except create interestitems on the two tax returns. So the transaction was ruled as just an attempt to deduct the cost of college as an interest expense.

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