The Bank of Mom and Dad: Benefits and Considerations of Intra-Family Loans
Intra-family loans can be as satisfying for our clients as they are beneficial for the recipients. The chance to take advantage of interest rates near historic lows makes their value even greater.
In the current environment of both ultra-low rates and onerous bank lending requirements, clients with excess cash are routinely lending to their grown children or grandchildren for home purchases and business startups.
Special precautions must be taken in setting up, documenting and following through on one of these loans in order to avoid the scrutiny of the Internal Revenue Service (IRS). First and foremost, the interest charged must be at or above the Applicable Federal Rate, or AFR, published on the IRS website monthly (more specifics on rates below). Otherwise, it will be deemed a gift and both sides could face negative tax consequences.
Top Benefits of Intra-Family Loans
Assuming IRS rules are complied with, however, the advantages are many. An intra-family loan:
- Provides the borrower with very competitive interest rates that most banks would not come close to matching even for their best clients.
- Allows a family member with a less-than-stellar credit history to purchase a house or start a new business.
- Enables parents to help a child or grandchild financially without it being a free handout; keeps the child or grandchild grounded by instilling the importance of paying the money back.
- Set up properly, does not affect the lender’s lifetime gift tax exemption, currently $5.45 million per individual.
- Avoids typical lending fees incurred with bank loans, such as administrative costs, closing costs and appraisal fees. And the loan can be structured so that there are no prepayment penalties.
Let’s Crunch Some Numbers
The Applicable Federal Rates include short-term loans for a term of three years or less. Mid-term AFRs are for a term in excess of three years but no greater than nine. And long-term AFRs are for a term in excess of nine years. With interest rates near historic lows, the October 2016 long-term AFR with monthly compounding is 1.93 percent.
Here is an example to show how immense the borrower’s interest rate savings can be.
Let’s assume a $400,000 intra-family loan was made for the purchase of a qualified or primary residence. With a term of 30 years at the 1.93 percent interest rate, the monthly payment would be $1,465. By comparison, a typical bank mortgage would be at a rate closer to 3.5 percent, where the monthly payment would be $1,796, more than $300 per month higher.
To minimize the monthly payment amount for the benefit of the borrower, the loan could be set up over a term beyond the conventional 30 years. Alternatively, the loan could be set up with interest-only repayments with a balloon payment at the end of the term. This too would lower the monthly payments for the borrower.
Just remember to follow the rules of such loans faithfully so the IRS does not come to the conclusion that this was designed as a gift from the beginning.
A Few Final Intra-Family Loan Tips
I recommend that intra-family loans be carefully documented so that the promissory note details the interest rate (no less than the AFR), recurring payment amount and term. For home loans, when the borrower is using the funds to purchase a qualified residence, the loan needs to be recorded as a lien against the property so that the borrower is able to deduct the interest expense on their income tax return. And remember to share with income tax preparers the amortization table which would quantify the interest income for the lender and interest expense for the borrower.
Loan payments can always be forgiven; this would be deemed a gift. For smaller loans the annual exclusion gift could be used to forgive interest and principal up to the current limit of $14,000 per person and per year. If a married couple loaned money to a child and the child’s spouse, the annual exclusion would expand up to $56,000 per year. If the forgiven interest and principal exceeds the annual gift exclusion amount, the lender would either need to use their lifetime gift exemption or pay gift taxes.
If an intra-family loan makes sense for your family, I recommend you consider doing one in the near future to lock in these extremely low rates. But these loans are not about trying to maximize your wealth. They are about helping out kids or grandkids at a great rate that we may never see again.