Loans to Family Members: What You Need to Know

Under the right circumstances, an intrafamily loan can be a powerful estate planning tool because it allows you to transfer wealth to your loved ones free of gift taxes — to the extent the loan proceeds achieve a certain level of returns. But an outright gift is a far more effective way to transfer wealth, provided you don’t need the interest income and have enough unused exemption to shield it from transfer taxes.

Generally, to ensure the desired tax outcome, an intrafamily loan must have an interest rate that equals or exceeds the applicable federal rate (AFR) at the time the loan is made. In August, 2020, the AFR rate will be at an historic low, of .41% for a mid-term loan (3-9 years).  The principal and interest are included in the lender’s estate, so the key to transferring wealth tax-free is for the borrower to invest the loan proceeds in a business, real estate, or other opportunities whose returns outperform the AFR, which should be easy to do for loans that have .41% interest.

The excess of these investment returns over the interest expense is essentially a tax-free gift to the borrower. Intrafamily loans work best in a low-interest-rate environment, when it’s easier to outperform the AFR.

If interest is not paid, that is considered a loan gift to the Borrower (child).  However, except for a de minimis gift, the Lender (parent) has to report interest income, even if not paid.  Here are the rules:

1. A loan of $10,000 or less is exempt.  In other words, no interest income has to be reported.
2. A loan of $100,000 or less.  The Lender reports imputed interest at the lower of the AFR rate or the Borrower’s (child’s) net investment income for the year.  With an AFR of .41%, very little imputed income has to be reported.
3. A loan of $100,000 or more.  The Lender has to report imputed interest at the AFR rate.

What happens if you forgive the loan.  Any loan forgiveness is considered a gift and can be sheltered from gift tax by either the annual exclusion ($15,000 per person) or the applicable exclusion amount ($11,580,000).

Finally, while forgiveness of a loan sometimes results in cancellation of debt (COD) income to the borrower, the tax code recognizes an exception for debts canceled as a “gift, bequest, devise or inheritance.” There’s also an exception for a borrower who’s insolvent at the time the debt is forgiven.

Contact us to discuss whether an intrafamily loan or gifting make the most sense for your personal situation.