The Family Bank
How can you help your children or other family members with large purchases? One solution could be the intra-family loan. Intra-family loans are a way to help children or other family members finance major purchases at an advantageous interest rate, and transfer or preserve wealth with a minimum of tax consequences for you or your heirs. While these loans can be quite helpful, it is important to remember is that this is an actual loan—not a gift. The borrower must pay the loan back.
Lower Interest Rate
Intra-family loans usually have a lower interest rate than standard loans, providing a potential to save thousands of dollars. Loans between related parties can use the “applicable federal rate” or AFR in accordance with Section 1274(d) of the Internal Revenue Code. The AFR is different for different maturities: short-term (three years or less), mid-term (more than three and up to nine years) and long-term (more than nine years).1 The actual rates are updated monthly and can be found on the IRS website here: https://apps.irs.gov/app/picklist/list/federalRates.html.
It is necessary to demonstrate that the money given to the family member is really a loan because otherwise the IRS will assume it is a gift. To prove this creditor-debtor relationship, you can use the following items:2
- Signed promissory note kept on file.
- Predetermined repayment schedule is put in place.
- A fixed interest rate is used for the loan—at least equal to the AFR for the month in which the loan is made.
- Collateral is requested from the borrower.
- Repayment of the loan is required.
- Records are kept of payments made:
- Family lenders should have a form 1099 prepared to show the interest income they received.
- For mortgage interest, family lenders should issue a form 1098 to the child to show the amount of interest paid. The child can use this to deduct the mortgage interest if they itemize.
- Borrower is solvent.
- No plan to forgive the loan.