Take a look at this popular way to shift wealth with a minimum of tax consequences for you or your heirs.

  • The intrafamily loan can be a simple and effective wealth transfer strategy, and is often underutilized.
  • 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, and are particularly beneficial in a low interest rate environment.

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 an heir 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 heir, and the loan is made to the trust rather than the individual, the wealth transfer benefits are further enhanced.

Low interest loans may also be a great way to help a child start a business, pay down a higher interest rate debt, even finance a home or car. However, it’s important to keep in mind that even in a favorable environment, the loan must be repaid. An imprudent investment, or a further downturn in market conditions, could leave a borrower without the means to repay the loan when due. Nevertheless, low interest rates, coupled with depressed market values of real estate, securities, and business interests, make the intrafamily loan a potentially important strategy to add to your estate plan.

Capitalize on interest

Once you understand how the IRS sets the minimum intrafamily loan interest rates, you’ll appreciate the full impact of the current opportunity. Loans must be made at or above the Applicable Federal Rate (AFR), which is set monthly by the IRS and is currently very attractive for estate planning strategies. The AFR rates since January 2012 to January 2017 have ranged between 0.19%-0.96% for the short-term loan (0-3 year), 1.17%-1.97% for the mid-term loan (3-9 years), and 2.63%-2.75% for the long-term loan (over 9 years). For the current AFR, visit www.irs.gov.

In a low interest rate environment, there is a higher probability that the rate of return earned on the investment of the loan proceeds will exceed the loan interest rate, allowing any appreciation in excess of the loan interest to pass to the borrower free of gift and estate taxes.

Pay attention to structure

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 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.

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.

If you’re considering an intrafamily loan, plan carefully how the arrangement could help you and your beneficiaries meet goals and what assets you’ll use to fund the loan. Consulting experts to draft a promissory note, and to provide income and transfer tax advice, will go a long way toward ensuring that your intrafamily loan supports your long-term estate planning goals.

This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service. It is not designed or intended to provide financial, tax, legal, investment, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought. 

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