Pay It Forward: A Primer on Intra-family Loans

In 1946, my grandparents, both children of Swedish immigrants, borrowed money from their parents and started a small business in New York City. With hard work and a good business plan, they were successful. Within a year, they had repaid the family loan and relocated their company to their hometown of Buffalo, New York, to be closer to friends and family. They ran the family business until their retirement, providing employment to hundreds of people over the years and making a significant impact on the community through their generosity. Today, the business has expanded significantly under the ownership and leadership of several of their children—my aunts and uncles—and has become a family business success story, all made possible because of an intra-family loan.

Are you looking for ways to “pay it forward” to your family? Perhaps an intra-family loan could be a useful tool to help you achieve the outcomes you desire. Whether you want to finance a new business venture like my great-grandparents did for their children or, more simply, help your son, daughter or grandchild purchase their first home, a properly structured intra-family loan is good option to consider.

A private loan to a family member can offer several advantages over traditional commercial loans, providing tremendous flexibility with relatively low upfront costs. For some families, an intra-family loan is also a powerful technique for transferring wealth. Before establishing the “Bank of Mom and Dad,” there are some important rules to be aware of to avoid creating unwanted gift or income tax outcomes.

A Sufficient Rate of Interest Needs to be Charged

Prior to 1984, taxpayers had the ability to make interest-free loans to family members with no resulting income or gift tax exposure. However, this treatment changed when the Supreme Court held in Dickman v. Commissioner that “the lender’s right to receive interest is a ‘valuable property right,’ and that the transfer of such right through an interest-free loan is a taxable gift.” This case led to the enactment of Internal Revenue Code Section 7872, which applies to below-market intra-family loans today. To avoid application of this code section (e.g., creating a taxable gift when it isn’t intended), an intra-family loan must bear a sufficient rate of interest, meaning a rate that is no lower than the applicable federal rate (“AFR”) at the time the loan is established. These rates are published monthly by the IRS and can be found on their website. Depending on the term of the loan, the short-term (0–3 years), mid-term (3–9 years) or long-term (longer than 9 years) rate will apply. If your note does not have a set term, referred to as a demand note, the short-term rate for the semi-annual period the loan is outstanding is applied, subject to certain rules.

Structure is important

If you are making a loan to a family member, you want to ensure that it is treated as a loan and not as a gift by the IRS. There is no “bright line” test applied to determine if an amount advanced to a family member is a bona-fide loan. Rather, the IRS will consider a variety of factors including whether (1) there is a signed promissory note, (2) interest is charged, (3) the lender has security or collateral, (4) there is a fixed maturity date, (5) any actual repayment is made or demanded, (6) the borrower has a reasonable likelihood of repaying, and (7) there are any records maintained by the lender and/or the borrower reflecting the transaction as a loan. The more of these factors you can “check off” the list, the more likely the IRS will consider your loan as bona fide and not a gift.

Income Tax Considerations

If you lend money to a family member, there are income tax consequences for both the borrower and the lender. The interest income received by the lender is considered interest income reportable on the lender’s tax return and is taxable at ordinary income tax rates. The interest paid by the borrower may be a deductible interest expense depending on the use of the funds. For example, if the loan is properly structured and is used to start a business, make investments, or buy a home, the interest payments may be deductible. If the loan proceeds are used for a personal expense or to pay off personal debt, the interest will not be deductible under current law. We advise that clients seek the advice of their CPA or tax counsel prior to extending a loan to understand the tax implications of the structure being considered.

Tax Implications of Loan Forgiveness

If you decide to forgive the interest due or any of the principal balance on an intra-family loan, it is important to recognize that this portion will be treated as a gift to the borrower. You can apply your annual exclusion amount (currently $15,000 per individual) or your remaining lifetime exemption amount to avoid paying current gift tax. In addition, the forgiven interest is still treated as taxable income to you as the lender and reportable on your tax return.

Protecting the Family Dynamic

As with any financial transaction involving related parties, there are risks that a private loan can introduce unwelcome dynamics to the family relationships. As an example, animosity may build between siblings if there is a perceived lack of fairness regarding the extension of credit from the family bank. Or consider the situation where a child becomes dependent on loans from their parents because of poor financial decisions while his or her siblings are living within their means, not seeking help from the “family bank.” Parents or grandparents who are considering lending funds would be wise to consider some important questions. For what purposes will you lend funds to a family member and on what terms? What will happen in the event a family member is delinquent or defaults on the loan? What will happen to the loan if you pass away with a balance outstanding? Do you want to provide substantially equal loans to all siblings, to use as they see fit?

Wealth Transfer Planning

As mentioned earlier, an intra-family loan—especially in a low interest rate environment—can be effective tool to shift a large amount of wealth outside of one’s taxable estate. This is best illustrated by an example. Let’s assume an individual with a taxable estate lends $5 million to their child in exchange for a 9-year interest-only promissory note at 0.86% (September 2021 mid-term AFR) compounding annually with the principal balance due at the end of the term. The proceeds are used by the child to invest in an investment that provides a 7% after-tax return.

With a “hurdle rate” of only 0.86% on the loan, a majority of the investment returns in this example accrue to the child, shifting a significant amount of appreciation—approximately $3.7 million—outside of the parent’s taxable estate. The parent receives back all of the $5 million loan but removes the $3.7 million of investment growth from his estate. It should be noted that this example assumes that the parent would have invested the money in the same investment had the funds not been lent to the child. This is what we often refer to as an “estate freeze” technique in estate planning. The $5 million value is “frozen” (i.e. not earning much at all to the lender) during the course of the loan.

In the case of wealth transfer planning, instead of lending money directly to the child, estate planners will commonly recommend utilizing irrevocable trusts as the borrower. If the trust is structured properly, the assets that accumulate in the trust will be outside the parent’s taxable estate as well as the estate of the child or future generations.

Conclusion

If you would like to discuss how intra-family loans can be used to achieve goals for your children or grandchildren, our advisors at Bragg Financial would be happy to talk with you. If used thoughtfully for the right purposes, loans to family members can help accomplish outcomes that leave a lasting legacy.

This information is believed to be accurate but should not be used as specific investment or tax advice. You should always consult your tax professional or other advisors before acting on the ideas presented here.