With current interest rates at near-historic lows, intrafamily loans remain an effective way to shift wealth to the next generation while avoiding estate and income tax consequences. Such loans can be part of a complex estate planning strategy, including the transfer of a closely-held family business. However, they can also be used as a simple mechanism to assist children with a major purchase or to help them pay down high-interest rate debt. A properly structured and managed intrafamily loan has the following benefits:
- Substantially lower interest rates than what would otherwise be commercially available;
- Flexible repayment options that can be tailored based on the borrower’s and lender’s needs;
- Interest payments made to family members rather than outside banks;
- No borrower credit checks or reporting and
- Reduced closing costs and associated expenses.
Rules and Requirements
In order for an intrafamily loan to be effective, it must be properly structured and documented to ensure that the Internal Revenue Service (IRS) considers it a bona fide loan and not a gift in disguise. The IRS takes the position that the transfer of money between family members is a gift unless the lender can show that he or she received full and adequate consideration in exchange for the transfer. The determination of whether a transfer is a gift or a loan depends on a number of factors. However, an intrafamily loan generally must include a “market” rate of interest, a set schedule of payments or principal/interest, a fixed maturity date, and documentation maintained by the lender and/or borrower reflecting the transaction. At a minimum, the lender should utilize a promissory note containing the loan terms to memorialize the agreement. However, the lender should also consider securing a pledge of collateral in the form of a deed of trust or a UCC-1 financing statement.
Applicable Interest Rates and Tax Considerations
To apply a “market” rate of interest, an intrafamily loan must require repayment using an interest rate at least as high as the Applicable Federal Rate (“AFR”), which the IRS publishes on a monthly basis under IRC Section 1274. There are three applicable AFRs used for 1) short terms loans of up to three years, 2) mid-term loans from three to nine years, and 3) long term loans of more than nine years. Notably, though the AFR is considered “market” rate, it is generally substantially lower than those charged by commercial lenders. For example, as of the date of this post, the average 30-year fixed mortgage rate is 4.22%, while the long-term AFR is only 1.92%.
It is also important to note that an intrafamily loan has income tax consequences both parties. For income tax purposes, interest received by the lender is considered taxable income and reportable on the lender’s annual return. If the borrower is unable to repay, and the lender forgives any portion of the loan, the amount forgiven may be taxable income to the lender to the extent it is not covered by the lender’s annual $16,000 gift tax exclusion. Under certain circumstances, if the borrower uses the loan principal to buy a home, start a business, or make certain investments, the interest payments may be tax-deductible.
How It Works
To illustrate the mechanics of a an intrafamily loan, consider a hypothetical family business. Owner wants to pass a portion of the business to Child, but the transfer would be subject to gift tax and use a portion of the owner’s gift and estate tax exemption. Instead, Owner obtains an appraisal for the business, then sells a portion of the business to Child, and takes back a promissory note guaranteeing payment at the current AFR. The sales price is set at the fair market value and discounted for the minority interest and lack of marketability. Child uses the income from the business to pay back the principal and interest on the loan. Meanwhile, Child (who is in a lower income tax bracket than Owner) pays income tax on the income generated by the proportionate business share. After the loan term ends, the value of the business interest has appreciated, the loan is repaid in full, and the size of Owner’s taxable estate is substantially lower without depleting his gift and estate exemption.
In today’s low-interest rate environment, intrafamily loans are an effective way to help the younger generation while reducing future gift and estate tax burdens. However, tax rules regarding intrafamily loans are complex, and can result in adverse and unintended tax consequences if not implemented correctly. At Jackson & Campbell, P.C., we remain available to develop a comprehensive loan strategy and assist in its implementation and administration.
The information provided in this article does not, and is not intended to, constitute legal advice. All information is for general informational purposes only. No reader should act or refrain from acting on the basis of information in this article without first seeking independent legal advice.