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.
Advantages for the Lender
Is it a good idea to loan money to family members? There are some pros and cons. Some advantages include:
- Family lender may earn a greater rate of interest on cash through the loan than from the bank.
- The money stays within the family rather than paying an outside bank.
- The family lender can help without giving money away. This helps a child learn to manage debt.
- The borrower’s credit rating may not allow them to obtain a loan from a retail lender. Intra-family loans do not get reported.
- The borrower may save on closing costs with an intra-family loan as compared with a retail lender.
Some disadvantages for the Lender
- The interest income is taxable to the family lender.
- Administrative burden—the loan must be properly documented, reported on income taxes, and administered to keep it from being treated as a taxable gift.
- The borrower could run into financial or personal issues where they are unable or unwilling to pay the loan back. This could result in family disputes.
- Loans to children for consumption purchases like a car or a boat may be inefficient for the family wealth. The interest is taxable to the parent-lender, thus generating taxable income for the family at a presumably high tax rate.
If the family lender does not need to be repaid and doesn’t plan to collect on the loan, a taxable gift to the borrower may be the best way to go, reducing the administrative burden. If the borrower’s financial needs can be satisfied through annual exclusion gifts, which are free of gift tax, the lender can consider making such gifts rather than setting up the more complicated intra-family loans.
Thoughts to Consider Before Becoming a Family Bank
Before becoming a “family bank,” it is advisable to hold a family meeting. In the meeting, the “lenders” have a chance to present their goals for the family and for the family assets, discuss their values, and present the proposed plan of action for the children, grandchildren, or other family members who will be receiving the loan. It is recommended that your financial advisor or another third party facilitate the discussion so that the meeting will remain professional and focused on the lender’s wishes. We recommend that you discuss these options with your financial advisor or tax specialist to see which approach is best for your situation.
1. Murphy C.B. & Berry-Johnson, J. (2020). Applicable federal rate (AFR). Investopedia. Retrieved from https://www.investopedia.com/terms/a/applicablefederalrate.asp
2. Akers, S.R. (2012). Estate planning issues with intra-family loans and notes. Retrieved from https://www.naepcjournal.org/journal/issue12c.pdf
The information provided is for educational purposes only and is not intended to be, and should not be construed as, investment, legal or tax advice. Allodium makes no warranties with regard to the information or results obtained by its use and disclaim any liability arising out of your use of or reliance on the information. It should not be construed as an offer, solicitation or recommendation to make an investment. The information is subject to change and, although based upon information that Allodium considers reliable, is not guaranteed as to accuracy or completeness. Past performance is not a guarantee or a predictor of future results of either the indices or any particular investment.