Proactive planning with low interest rates through intra-family loans
Do you have loved ones you want to help, but are not yet ready to donate important goods? Would you like to take advantage of the low interest rate environment and transfer your wealth profitably with minimal tax consequences?
Current economic conditions and market volatility have left many people unsure of the future. Yet it’s important, perhaps more than ever, to continue to seek wealth planning opportunities and not lose sight of the things that matter most in life, which for many start with loved ones. For those looking to engage in wealth planning while helping a loved one who is less financially secure than a short time ago, one strategy that can help achieve both goals is an intra-family loan.
What is an intra-family loan?
An intra-family loan is a loan between family members (or other relatives) that usually carries a lower interest rate than commercial loan rates. These loans can be made directly to the borrower or to a trust created for the benefit of the borrower. Intra-family loans are often used to provide liquidity to the borrower, whether to help them through a time of financial difficulty or to achieve a specific goal, such as buying a home or starting a business. . In addition, intra-family loans can instill a sense of responsibility in the borrower because, unlike an outright gift, the borrower must comply with the terms of the loan.
How an intra-family loan works
If the lender in an intra-family loan establishes a good faith creditor-debtor relationship with declared interest equal to or greater than the applicable federal rate (AFR) published monthly by the Internal Revenue Service, the intra-family loan will be treated as a loan and not as a transfer subject to donation tax. In order to establish the creditor-debtor relationship, the lender should strive to formalize the loan by creating a promissory note, a fixed payment schedule, and payment records. If the loan is for a large asset, such as a house, the lender must document the collateral or collateral (for example, a mortgage).
A key feature of an intra-family loan is the interest rate because the AFR is generally lower than the rates charged by commercial lenders. If the borrower can get a return on the amount borrowed that is greater than the AFR, then this excess appreciation benefits the borrower rather than the lender. Additionally, intra-family loans allow interest charges paid over the life of the loan to stay within the family and can save the borrower on some of the ancillary costs of the loan, such as administrative fees. and closing costs.
Another advantage of intra-family loans is that they can be structured however the lender sees fit, provided the interest rate is adequate and the loan is repaid. This means that the loans can be tailored to the needs of the borrower. For example, a loan could be structured with interest payments only during the term of the loan and a lump sum payment of principal at the end of the term, to allow the borrower to take full advantage of the maximum growth potential of the principal borrowed.
Using intra-family loans in a low interest rate environment
Perhaps now is the perfect time to give a loved one a loan, as many assets have fallen in value and AFRs are currently at all time lows. (As of May 2020, AFRs will vary from 0.25% to 1.15%, depending on the term.) If the borrower uses the loan proceeds to purchase a collection asset that generates a return greater than the AFR, then the grantor will have effectively transferred any capital gain on the AFR to the borrower without transfer fees. Additionally, if the intra-family loan is used for a specific purpose, such as buying a home, then taking advantage of historically low AFRs with an intra-family loan rather than a business loan can generate significant savings in interest payments. for the borrower.
Anyone considering an intra-family loan should carefully consider the impacts of granting the loan on the lender, the borrower, and their wealth planning goals. Additionally, if the lender and borrower believe that loan repayment may be a concern in the future, they should carefully consider the potential consequences of non-repayment before the loan is made. It is important to consult with qualified experts for income tax and transfer advice and to determine if an intra-family loan is the best planning option.
Learn more about Lifetime gift planning.