Borrowing from Mom and Dad after a certain age can make you bristle if you’re otherwise independent and accustomed to supporting yourself. However, it can make solid financial sense for both parties in certain cases.
An intra-family loan should have an interest rate of at least the Applicable Federal Rate (AFR), which is published monthly by the IRS here (https://apps.irs.gov/app/picklist/list/federalRates.html). There are AFRs for different loan terms. The short-term AFR can be used for loans up to 3 years. The mid-term AFR can be used for loans over 3 years but less than 9 years. The long-term AFR is used for loans over 9 years.
The IRS publishes the AFR monthly. For July, the long-term AFR with monthly compounding was 2.16%. This rate is lower than what you can obtain from most commercial lenders, which generates savings for the borrower. A $300,000, 15-year loan at 3% will cost the borrower $72,914 in interest. If the rate is the AFR, the borrower will pay $51,488 in interest over the life of the loan. Interest savings will be $21,426. Furthermore, the monthly payment will be $119 less because of the lower interest rate.
There is little to no burden on the borrower to prove he or she is a good debtor. Mom and Dad need not follow the lending standards of banks. Therefore a child with a low credit score would be able to obtain a loan from his parents when he might not be able to obtain financing from other lenders.
However, there needs to be an expectation of repayment or else the loan might be challenged by the IRS. For a particularly risky borrower, consider having some sort of collateral on the debt. Loans made to trusts often require the trust have assets or “seed funding” for this reason.
Income Tax Considerations
The parents must report and pay income taxes on the interest paid to them. The children will be able to deduct the interest paid depending on how they used the loan proceeds. For example, if the loan is a mortgage on a home, the interest will be deductible subject to the usual rules around mortgage interest deductions.
As long as the interest rate is at least the AFR, there are no additional imputed interest or gift-tax concerns.
Benefits to the Parents
Other than helping the kids, what is in it for the parents?
To parents, wealth transfer is the main benefit of an intra-family loan. Loans are often used as an “estate freeze” technique. For estate tax purposes, the value of the loaned funds is locked in at the value of the note and earning very little interest. If the children then invest the funds, the future appreciation will be outside of the parent’s estate. Potential opportunities arise if the expected growth or income of the investment exceeds the interest cost of the note.
Also, if structured properly, the loan will not be a gift and therefore will not utilize the annual exclusion or lifetime exemption. This makes intra-family loans a particularly useful wealth-transfer tool for those who have already used their lifetime exemption or are otherwise hesitant to dip into it.
We will delve deeper into the uses of intra-family loans in future posts.
If you are going to make an intra-family loan, get it in writing. Have an attorney draft proper notes. This adds legitimacy and clarity to the transaction should it ever be contested. Additionally, the family needs to treat the loan as a bona fide loan. Payments need to be made on time and thorough records need to be kept.
One of my greatest concerns with intra-family loans is the family dynamic. Is there is any concern about a child being unable to repay the loan? If a child defaults, how will the parents respond? Is the debtor/creditor relationship going to make Thanksgiving dinner awkward? All parties need to be open and honest about their comfort level with intra-family loans before executing this strategy.