Intra-family loans present the opportunity to borrow money at substantially lower rates than available by traditional mortgage. The key is to borrow at a rate equal to or higher than the published Applicable Federal Rate (AFR rate) which is the minimum rate to have a loan not qualify as a gift under IRS rules. There are three tiers of ARF rates relating to different term lengths (short, medium, and long-term). The published AFR rate for a long-term loan executed in April 2021 is 1.96%, and the IRS recommends implementing a rate ranging from 110% to 130% of AFR rates, or 2.16-2.55%. Given that current interest rates are approximately 3%, intra-family loans can result in substantial savings.
AFR rates are published a month in advance by the IRS. This creates an advantage because lenders can choose between executing a document in the current month or waiting a month to take advantage of more favorable rates.
Intra-family loans are governed by a promissory agreement. Like a mortgage agreement, this document details the terms of the loan. These terms are best determined as part of a collaborative discussion to ensure all parties have the same expectations. It should include:
- Interest Rate (locked in for the loan term at the time of signing)
- Loan term (length of time loan is in effect)
- How it will be repaid (Interest only? Balloon payment? Amortized and paid monthly?)
- How late payments will be handled (are there fees for late payments?)
- What happens if the loan is not repaid (if in default?)
- Whether the loan can be paid off ahead of schedule (are there repayment fees?)
Questions to frame a conversation before lending/borrowing funds:
When preparing for a conversation with your loved ones, ask yourself the following:
- What is your relationship? Do you have confidence the loan will be repaid?
- Do you have the liquidity to make this loan? Consider that if forced to sell investments to raise cash, you may be subject to substantial gains. Alternatively, do not sacrifice your own emergency fund to lend money to another family member – you risk putting yourself in a cash flow crunch.
- Are you considering making a loan or an outright gift? (discuss the differences)
- If a loan – For each of the terms above, what do you think is fair? (discuss each of the bulleted items, e.g., rate, term, etc.) – and document these decisions.
What happens if you decide to forgive all or part of this loan?
Some families may decide to use an intra-family loan to structure a large gift without paying the accompanying gift tax. In this case, families create a loan document, and each year when the payment is due, “forgive” the amount of interest/principal due, up to the annual gift tax exclusion ($15,000 each for 2021). This can be a very effective strategy, but there will be additional tax and administrative burdens.
- No matter if you later decide to forgive part of the loan, create a proper promissory agreement at the onset lest it be construed as a gift from the start.
- As stated above, if you forgive any portion of the loan, this is considered a gift. Any “gift” in excess of the annual gifting limits will need to be reported on a gift tax return.
- The amount of interest forgiven is still considered taxable income to you, the grantor. Your financial advisor and CPA can assist you in calculating the amount of interest due each year and documenting correctly on the tax return.
- Some attorneys recommend transferring the amount of the gift you plan to make to you child each year. The child may turn around and pay the loan payment with this money, but these transactions demonstrate the child chose to pay the amount due (as opposed to the child never having any plans to pay), reinforcing to the IRS that this is a legitimate intra-family loan.
Intra-family loans can be particularly useful for borrowers who would otherwise by subject to higher rates due to their credit score (or lack of credit history, especially if they are younger). The borrower can take advantage of lower payments than they would be subject to with conventional lenders, with no underwriting requirements.
We recommend working with an attorney to draft the promissory agreement and sharing the document with your financial advisor and CPA to ensure your loan is executed correctly.
Important disclosure information
Please remember that different types of investments involve varying degrees of risk, including the loss of money invested. Past performance may not be indicative of future results. Therefore, it should not be assumed that future performance of any specific investment or investment strategy, including the investments or investment strategies recommended or undertaken by RegentAtlantic Capital, LLC (“RegentAtlantic”) will be profitable.
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This article is not a substitute for personalized advice from RegentAtlantic. This article is current only as of the date on which it was sent. The statements and opinions expressed are, however, subject to change without notice based on market and other conditions and may differ from opinions expressed in other businesses and activities of RegentAtlantic. Descriptions of RegentAtlantic’s process and strategies are based on general practice and we may make exceptions in specific cases.
RegentAtlantic does not provide legal or tax advice. Please consult with a legal and or tax professional of your choosing prior to implementing any of the strategies discussed in this article.