By: Randall A. Denha, J.D., LL.M.
Many wealthy individuals find themselves in a hurt-of-sorts following the end of 2012. The top marginal bracket for taxpayers with more than $400,000 (single and $450,000 married) increased to 39.6 percent. Taxpayers with adjusted gross income in excess of $250,000 will pick up an additional 3.8 percent on unearned income raising the top marginal bracket to 43.4 percent. In addition, there are phase outs of personal exemptions and certain deductions that these same persons will now face.
Considering all of the negative tax changes affecting the wealthy individual, now may be a wonderful time for these individuals to consider the use of loans to other family members as legitimate wealth transfer tools. The typical intra-family loan is a cash loan between family members. Usually the loan is between the senior generation as lender to a junior generation as the borrower. The loan arrangement is captured in a promissory note with or without security for the loan.
In order to avoid the tax rules for below market interest rate loans under the tax code, the minimum interest rate for the loan must be equal to or greater than what is commonly referred to as the applicable federal rate based upon the length of the loan. As of the time of this writing, the current AFR for short term; mid-term and long term loans for March 2013 is .22%, 1.09% and 2.63% respectively. The low interest rate environment makes the Intra Family Loan an ideal estate planning strategy. The following is a brief overview of some ways in which intra-family loans can be employed along with some of the associated benefits.
Senior family members often lend or give money to their children or grandchildren to buy a home, start a business or get an advanced degree of education. In some cases a loan can be better than a gift and provide and afford an element of asset protection for all involved. For example, if parents lend a child funds to purchase a home that is purchased with the child’s spouse, followed by the child’s divorce, the in-law spouse may get less than if the funds were a gift. I often recommend that a mortgage be taken against the house and a corresponding promissory note be executed memorializing the loan. Or perhaps it is important to provide funds equally to all children, but family dynamics indicate that funds for some be provided as a loan rather than a gift. In addition parents may not realize that such loans, if properly executed and documented, can be powerful wealth transfer tools for reducing tax exposure. This couldn’t be truer than in today’s low interest rate environment, when IRS regulations that apply to how much one should charge on a loan are exceptionally favorable.
Overall, as stated previously, the rate that the IRS requires be paid on a “family loan” will vary depending upon the term of the loan and this rate is set monthly by the IRS. Nonetheless, this rate is still lower than the possible rates of return on the borrowed funds. As an example, providing a loan at an interest rate of 2% to your child who then invests that money and earns an 8% return allows for an opportunity shift to the next generation of not only wealth but also the obligation to pay income tax. This type of loan can enable a family borrower to purchase a home, start a business, pay off student loans or make another investment that could provide a significant annual rate of return in excess of the interest rate being paid. The spread between the interest rate and the actual rate of return is in effect a gift by the lender. With a large loan, this gift can amount to many thousands of dollars. Of course many existing loans can be negotiated to extend the length of the term to provide additional shifting of benefits provided it still makes sense.
But wait there’s more-here are other benefits to an intra-family loan. For example, when properly documented, a loan will not constitute a gift, and thus will not trigger gift tax or the use of lifetime exemption. Additionally, it will also freeze the value of the loaned assets with regard to the lender’s taxable estate, since once the loan occurs, the lender’s estate will include only the balance of the note and payments received, not the appreciation that may occur afterward on the loaned assets. Furthermore, if the money is used by the young borrower to invest in real estate or certain business assets, the limited interest he or she pays may be tax deductible.
Recall that since it’s a “family loan” the terms and conditions of the loan may not be as strict as a traditional third party loan with say a bank. If the debt cannot be repaid in full or on time, the lender may also forgive or refinance all or part of the debt. Depending upon the circumstances of the loan, this may trigger income tax consequences for the borrower or gift tax consequences for the lender, but the timing of the refinancing or forgiveness can sometimes be managed for optimal results. Also worth noting is that there is no generation-skipping transfer tax applicable to loans made to grandchildren or other later generation borrowers, whereas a tax or the use of available exemption would generally apply to gifts made to those individuals.
The rules applicable to an intra-family loan require that the agreement be in writing, set at least the applicable IRS interest rate and contain a fixed schedule for repayment. The lender and borrower should also keep accurate records of all principal and interest payments in case the loan is ever questioned by the IRS.
THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. THE MATERIAL IS BASED UPON GENERAL TAX RULES AND FOR INFORMATION PURPOSES ONLY. IT IS NOT INTENDED AS LEGAL OR TAX ADVICE AND TAXPAYERS SHOULD CONSULT THEIR OWN LEGAL AND TAX ADVISORS AS TO THEIR SPECIFIC SITUATION.