Often, I am asked for my opinion on making loans to family members. The client’s son wants to purchase a new home but wants his inheritance now to do so. An intrafamily loan is a financial arrangement between family members—one lending and another who is borrowing. An intrafamily loan may help a family member who needs money for several reasons:
It can feel satisfying to lend to a child or grandchild. Your loved ones can benefit from flexible repayment terms and interest rates while learning financial responsibility. This can be beneficial if the child or grandchild would otherwise have difficulty obtaining a loan through more traditional methods. It also allows you to increase your investment income, providing a sense of financial security and confidence.
How you give or loan money to family members has potential tax implications. The correct method depends on your family's circumstances.
An intrafamily loan might benefit estate planning for wealth transfers between generations while minimizing estate tax implications. By using an intrafamily loan to provide money to a family member rather than making a gift, you can maintain control over the principal amount and how it is used. This control is a powerful tool for preserving wealth and offers these advantages:
Under current tax law, gift and estate taxes are not imposed on gifts up to $13.61 million for individuals and $27.22 million for married couples in 2024. While many people’s net worth is not that high, intrafamily loans may be an excellent option for high-net-worth families.
If the family member receiving the loan invests the money and the investment returns on the borrowed funds exceed the interest rate charged, the excess growth is passed to your family member without being subject to gift or estate taxes. This strategy preserves your lifetime estate tax exemption amount if the formalities of loan issuing are observed. However, the initial loan amount (the principal) and interest owed to you will still be included in your taxable estate because the principal and interest are legally required to be paid to you. However, as previously mentioned, the growth in the investment will not be included in your taxable estate.
You might also consider loaning the money to a family member's trust as part of your planning strategy. Instead of loaning funds directly to your family member, the loan would be made to the trust. If the rate of return from investing the loan proceeds exceeds the loan’s interest rate, the excess is considered a tax-free transfer to the trust.
With intrafamily loans, you can set the interest rate at a level lower than commercial lenders if the rate is not below the Applicable Federal Rate (AFR) (read below for further discussion on the AFR). The cost savings for the borrower can be significant. Further, if the AFR is high when you initially make the loan, it may be easier to reissue the note from you to take advantage of any future lower interest rates than it would be to refinance a note from a third-party lender.
Intrafamily loans can be crucial in transferring a family business from generation to generation. By providing financing to family members who wish to take over the family business, you can ensure a smoother transition and help sustain the family legacy.
Determining the interest rate for your intrafamily loan is crucial to avoid unnecessary tax consequences. The Internal Revenue Service (IRS) publishes AFRs monthly, broken down into three tiers: short-term, mid-term, and long-term rates. Rates can be fixed or variable and structured to the advantage of both parties. The minimum AFR rate must be charged for loans over $10,000 regardless of a loved one’s credit rating, and it is usually lower than most commercial lenders. Suppose the interest rate for your intrafamily loan is below the AFR. There, the IRS may require you to pay income tax on the income you should have received under the applicable AFR even though the borrower did not pay you that amount (called imputed interest). Also, the amount of interest you did not collect but should have may be considered a taxable gift to the borrower, potentially reducing the amount of gift and estate tax exemption available to you.
Since the IRS generally assumes that wealth transfers between family members are gifts, it is essential to have the proper documents showing that the transfer is intended to be a loan. You and your family must sign a promissory note adhering to the state-specific rules to document the loan transaction properly.
A comprehensive written promissory note is crucial. It helps avoid unnecessary tax consequences and communicates the loan between family members to prevent misunderstandings and conflicts.
Every financial decision has the power to strain family relationships. When trying to determine if an intrafamily loan is right for your situation, ask these questions:
You must carefully consider the decision to gift versus use intrafamily loans, including the income, estate, and gift tax implications. The tax rules about intrafamily loans are complex and may result in unintended consequences if the loan is not done correctly. If you already have an intrafamily loan, it is crucial to properly document it in your estate plan to ensure that everything will proceed smoothly if you pass away before the loan has been paid back. If you are considering making an intrafamily loan, call the attorneys at Altman & Associates at 301-468-3220 or through the website at altmanassociates.net.
