With Rates Rising, Now May Be the Time for Intra-family Loans 

Clients considering a loan to a family member may want to implement one before the IRS raises rates higher.

By Assunta McLane

More and more, we’re being asked by clients, “What can I do to help my child purchase their first home?” We’re especially hearing this due to the rise in interest rates and the increased costs of buying that first home.  A strategy called an intra- family loan may be especially beneficial in this type of situation.

An intra-family loan can be a great way to help a family member purchase a home, maybe invest in a business, or even pay down debt. As the parent, your client is typically the lender and the recipient is typically their child. This type of loan, if set up correctly under IRS requirements, can be beneficial to all parties. One of greatest benefits is there is lots of flexibility.

That being said, there are a few key things your clients should consider before determining if an intra-family loan may be right for them and their family.

Why are intra-family loans a great idea?

If your clients have the financial means to loan the money, these loans offer a great advantage to their children. They can lend as much as they like, regardless of their personal financial position. Also, within IRS guidelines, they can set the rates and terms that best fit their circumstances.

The lender will pay taxes on any payments that they receive. Many successful families view this as a gift to their children in that they are paying taxes for them on money that is part of their estate. The lender also has the opportunity to forgive all or part of the loan, giving them another strategy for managing their estate value by essentially giving their children an appreciating asset, such as their home.

How do you determine the appropriate loan terms and rate?

The IRS sets what is called the Applicable Federal Rate (AFR), which changes monthly and is used for intra-family loans. The rate your clients choose will vary depending on the terms of the loan. The IRS breaks out rates into three different tiers: a short-term loan is up to three years; a mid-term loan is three to nine years, and long-term loans are more than nine years. We find that most families use the second tier (up to nine) years) even in situations where they anticipate it being longer than nine years, since they have the flexibility to then amortize the loan again once the first term has ended.

The AFR is typically a much lower rate than what a bank would charge and the borrower’s credit does not impact the loan rate.

Once your client has agreed upon the term of the loan and the appropriate rate according to the IRS, a promissory note can be drafted with their own personal terms. For example, they may want to structure the payments like a traditional mortgage with regular interest and principal payments. Or, to make the loan more affordable to their family member, they might structure the loan only with interest payments and a balloon payment expected at maturity.

When maturity comes, they can choose to re-finance their own promissory note to stretch it out further or adjust the payment terms.

The promissory note will reflect the loan terms they choose, including the rate, payment structure and what is to happen if the loan were to go into default.  The agreed upon rate should be set at or above the AFR and payments can be set up as monthly, bimonthly or semiannually.

It is important to properly structure the loan because if done incorrectly there can be unexpected income and gift tax consequences. For example, if your client were to lend their child $100,000 so they could buy their first home and they agree not to charge interest, this could be defined as having made a gift to them and a gift tax return would need to be filed.

However, if they were to charge interest at least equal to the AFR, then your client as the lender would report the interest income and their child as the borrower may be able to deduct the interest expense. This avoids any income or gift tax issues.

Having the proper paperwork in place is important for purposes of record keeping and eliminating any uncertainty.

What if part or the whole loan is forgiven?

The simplest way to make a gift is to forgive the interest/principal payments each year up to the annual gift tax exclusion amount. For this year, the amount is $16,000. Your client and their spouse can each forgive $16,000 to the borrower. If the amount they forgive is less than the annual exclusion amount, no additional paperwork is required.

If as the lender they decide to forgive a greater amount or maybe the entire loan, this will be considered a gift against their lifetime gift exclusion and a gift tax return will be required. The amount of interest forgiven may be considered interest income to the lender for that year.

Additional Reading: Helping Clients Gift a Down Payment 

With either option, it is important your client work with you and an accountant to calculate the correct payments and interest and to properly record all transactions.

How to initiate a conversation with a family member

Sometimes initiating the conversation about a family loan may feel uncomfortable for clients and their children. It may feel as though they are intruding into their personal finances. If so, you as their financial advisor can initiate a family meeting. You can help explain the opportunity, answer questions and facilitate the conversation.

When having this discussion, you will want to make sure they understand that the loan will work similar to borrowing money from a bank, but at a much better interest rate. There will be a formal written document to sign that spells out the terms of the loan and the consequences if they don’t make their payments.

You may also choose to share that not only do your clients want to do this to help their family member, but that it is a beneficial tax and estate strategy for your clients too. This can help the family member see that the loan is not a handout.

Remember, it is always important to first consider your client’s personal financial situation before they decide to make any kind of loan.  An intra-family loan can have a very powerful impact on your client and their family member but only after careful consideration and conversations with you, their financial advisor.

Assunta “Susie” McLane CFP, is a vice president and senior wealth advisor with Summit Place Financial Advisors LLC.  She can be reached at Assunta.Mclane@summitplacefinancial.com or 908-517-5884. 

Latest news

Carson Group: Still Too Few Women in Wealth Management

Its latest report confirms the industry has made little progress in gender diversity despite a lot of talk.

Supreme Court Seems Wary of SEC’s In-House Tribunals Without Juries

The Supreme Court discussed a case involving a hedge fund manager in which the SEC brought a civil enforcement proceeding that charged he mislead investors.

Annuity Sales Continue March Upward

Annuity sales are set to have another record-breaking year, based on results in the third quarter.

Humana, Cigna in Talks to Merge

A deal would give Cigna a much greater foothold in the fast-growing market for managing federal Medicare plans for older Americans.

Aretha Franklin’s Sons Awarded Late Singer’s Real Estate

They now own the late singer's real estate after a judge ruled that a handwritten will found hidden in her sofa was the correct document.

The Wit and Wisdom of the Late Charlie Munger

Charlie Munger, Warren Buffett's deputy who helped transform Berkshire Hathaway into a conglomerate, will be remembered, in part, for comments like these.