Despite the Federal Reserve’s December quarter-point hike, interest rates remain near historic lows. In this low-rate environment, intra-family loans remain a great wealth transfer tool for affluent individuals and couples.
You can make a low-interest intra-family loan to your children or grandchildren for any purpose you choose. For example, you could loan them money to buy a home, finance a wedding or start a new business.
With interest rates currently as low as 0.61% for short-term loans of up to three years, intra-family loans can prove to be a source of low-cost capital for your children or grandchildren. At the same time, they’re a great way for you to transfer wealth to the next generation without using up your lifetime gift tax exemption of $5.45 million, or $10.9 million for you and your spouse together.
Interest rates rise slightly for longer-term loans. Each month, new applicable federal rates (AFRs) are published by the IRS. For February, the short-term adjusted AFR is 0.61% (as noted above), the mid-term (up to nine years) adjusted AFR is 1.39%, and the long-term (10 years and longer) adjusted AFR is 2.53% (compounded annually) These rates are still a bargain compared to a bank or credit union consumer loan or mortgage.
Is there a catch to this strategy? Not really — the most important thing to remember is that the loan must be structured as a true loan. If the loan is forgiven or the IRS determines that it’s really a gift, you’ll either have to use your gift tax exemption or pay gift taxes of up to 40%. And the borrower will have to pay income tax on the amount forgiven at his or her ordinary income tax rate.
The best way to avoid this scenario is to create a promissory note and a fixed payment schedule, secure the debt, and keep records of everything. Borrowers, meanwhile, should make loan payments on time and remain solvent. As the lender, you must report loan interest you receive as taxable income. If the loan is for less than $10,000, though, you don’t have to charge interest.
Lock in Low Rates
Another attractive feature of intra-family loans is that even though AFRs change monthly, you can lock in the current low rates for the term of the loan. With rates likely to continue rising in the future, this could be a very smart strategy, especially for long-term loans. For example, using a 30-year intra-family loan, your child or grandchild could buy a home and lock in a long-term interest rate of just 2.53% (in February).
It’s a good idea to seeking professional assistance in structuring an intra-family loan to help ensure that it stands up to scrutiny if it’s ever challenged by the IRS. Talk to your wealth advisor first, who may also bring in an attorney to draft the note and an accountant to scrutinize the financial aspects of the transaction.
Please give us a call if you have more questions or need assistance with an intra-family loan. We can help make sure the loan is structured properly and bring in additional outside expertise as necessary to help ensure a smooth transaction with no nasty surprises later.