Using Intra-Family Loans In A Low Interest Rate Environment

By: Randall A. Denha, J.D., LL.M.

When interest rates are low, intrafamily loans can be a good way to assist a relative (typically a child) with purchasing a house or a family business, and in certain circumstances they can be used to gift money to the next generation. 

Savvy investors are always seeking opportunities, no matter what the economic backdrop. Although low interest rates may put a damper on some returns, the low rates also provide wealth transfer opportunities. Intrafamily loans are a popular way to take advantage of a low interest rate environment to shift wealth with a minimum of tax consequences for you or an heir.

With an intrafamily loan, parents can provide a financial resource to their children for a specific use, or create a trust for their benefit. The rates used for intrafamily loans are typically more attractive than what may be available commercially, which will be discussed in detail later in this article. Additionally, these loans can offer greater flexibility than commercial loans, as payment terms may be structured based on the specific needs and circumstances of the child.

An intrafamily loan comes with no limitations on how a borrower uses the proceeds. This feature provides a great advantage in a market environment in which interest rates are low and valuations on a wide range of assets have fallen dramatically. With the cost of borrowing so low, it will be much easier for a child to use his/her loan to fund an investment that outperforms its interest rate.  The tax benefit is as follows: the difference between the low interest rate on the loan, and the rate of return on the assets purchased with the loaned money, passes to the family member receiving the loan without payment of any transfer tax.  Further, if a certain type of irrevocable “grantor” trust is established for the benefit of the child, and the loan is made to the trust rather than the individual, the wealth transfer benefits are further enhanced.

An intrafamily loan allows family members to borrow money from each other at a special rate, but it must be structured properly so that the loan is not considered a gift. This means the loan must have a written promissory note, require repayment, and charge interest (if the loan is for more than $10,000). The IRS sets the Applicable Federal Rate (AFR) each month, and the interest on the intrafamily loan must equal the AFR. The rate is different, depending on the term of the loan, which can be a short-term loan (0-3 years), a mid-term loan (3-9 years), or a long-term loan (9 or more years). The AFR is typically lower than the interest rate a bank would charge, and the borrower’s credit doesn’t affect the loan, so someone with bad credit can still get a loan. 

When structured properly, intrafamily loans can assist children with purchases and pass on assets. The following are some of the ways intrafamily loans can be used: 

• Pay for a house. An intrafamily loan can be used to fund a mortgage for children or grandchildren. Because the interest rates are lower, the children will pay less overall than going through a traditional mortgage lender. 
• Pass on a family business. Depending on how large the business is, giving away a business could exceed the prevailing gift tax exemption. Instead, parents can loan money to a child to purchase the family business. Parents who are financially able could use the annual gift limit ($15,000 in 2021) to give children money to repay the loan. Alternatively, if the family business produces income, the child can use the income to pay back the loan. Even if the business doesn’t exceed the gift tax exemption, this can be a good strategy for parents who want to pass on the business, but still need a steady income stream. 
• Pass on assets. Intrafamily loans can be used as a method of passing on assets provided the borrower can invest the money in a way that brings in a higher rate of return than the interest rate on the loan. Given the low interest rate on intrafamily loans, this can be a successful strategy. If the loan is a large one, it may be wise to loan the money to a family trust. The trust invests the money and repays the loan. After the loan is repaid, the remaining assets are protected by the trust and can be distributed to beneficiaries as dictated by the trust terms. 

Adjusting the loan’s structure could make it even more useful to the borrower. By choosing a balloon note and requiring interest-only payments for the duration of the loan with the principal due at the loan’s expiration, your child could enjoy maximum opportunity for principal growth. Or, you might wish to set a monthly or annual repayment schedule of both interest and principal. However, keep in mind that interest payments will be treated as taxable income to the lender. Applying your $15,000 annual gift tax exclusion to a portion of the interest can further enhance the loan’s efficiency from a gift tax perspective; however, the lender will still be subject to income tax on the interest.

Aside from the administrative burden of properly documenting and managing an intrafamily loan, there are other issues to consider when deciding whether an intrafamily loan is a good fit, such as:

• The interest income is taxable to the lender and not tax deductible to the borrower unless, as to the latter point, the loan qualifies as a mortgage and the payments are within the then current mortgage interest deduction limits.

• The borrower may be unable or unwilling to pay back the loan, which may cause family discord or result in the loan becoming a taxable gift. If this risk exists, it may make more sense for the parent(s) to make an annual exclusion gift. The current amount that can pass by gift from one person to another person without using any portion of the donor’s lifetime federal gift tax exemption is $15,000. Two parents can give one child $30,000 per year under the annual exclusion. The annual exclusion is indexed for inflation.

Also keep in mind that since an intrafamily loan is created with the full intention of repayment, it is critical to record the loan terms in a promissory note and to track payments of interest and principal under the note. If the loan is not properly documented and followed, the IRS could reclassify the loan as a gift, and tax it accordingly. In the same vein, if your heir defaults, you may forgive the loan by making a taxable gift. If the loan is outstanding at the time of your death, your Will may provide for it to be forgiven. The tax regulations regarding defaulted loans and forgiveness of indebtedness can be complicated, and it’s best to consult with your tax advisor on these issues before you establish the loan.