Benefits of Intra-Family Loans: Tax Considerations

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Many customers use intra-family loans to help a relative buy a home, finance a business, or invest in another asset. When properly designed, intra-family loans also provide customers with an excellent tax planning strategy. To avoid any portion of an intra-family loan being considered a gift for tax purposes, a customer should follow certain guidelines, including charging a minimum interest rate, documenting the loan, and requesting payment under the loan terms.

The applicable federal rate.

One important rule is that the loan must be paid an interest rate equal to or higher than the applicable Federal Rate (“AFR”). The AFR for each month – those received by the IRS on or around Jan.the Day of the previous month – is divided into three levels depending on the loan term: the short-term interest rate applies to loans up to three years, the medium-term interest rate applies to loans with a term of between three and nine years, and the long-term interest rate applies to loans with a term of more than nine years.

The historically low prices for August 2020 are:

Short term – 0.17%

Medium term – 0.41%

Long term – 1.12%

The current AFR makes intra-family loans a particularly attractive instrument for estate planning.

Repayment structure.

It is important that the terms of the loan are met. The loans can be structured in different ways. Customers often choose one of the following three payment terms:

Interest payments only. Under this arrangement, the borrower pays interest to the lender annually and makes a balloon capital payment at the end of the payment period.

Amortized Payments. The borrower pays a certain monthly amount, which pays off the interest and principal payments during the entire term of the loan.

Accrued Interest. The interest on the loan is currently not paid, but is added to the principal amount due annually. All interest and repayments are due at the end of the loan term.

In general, the Amortized Payment structure costs the borrower the least interest and the accrued interest plan costs the borrower the most interest. Note that the interest cost differential between the individual strategies becomes more pronounced as the interest rates rise. Choosing which payment structure to use depends on the overall goal for using the intra-family loan.

Security.

In addition to the payment structure, the customer should consider whether he wants a security for the repayment of the note. For example, if the funds raised are used to buy real estate, there is usually security in the form of a mortgage on the property, which would be beneficial to protect the customer’s interests in the bond and property from claims made by the creditors of the spouses Borrower’s divorce. The mortgage can also be beneficial if the borrower later attempts to refinance the mortgage through traditional banking methods. A mortgage can also allow the borrower to deduct interest expense from their personal income tax return.

Note forgiveness.

With an intra-family loan, sometimes the lender may want to waive part of the note from time to time. While this can be an effective strategy, there are important considerations to keep in mind:

Income tax. If a lender waives interest on a promissory note, that lender must still recognize the lost interest as income.

Gift tax. To avoid the argument that the entire loan is a taxable gift, the lender must avoid any implication that there was a pre-arranged agreement to waive the borrower’s interest or principal payments. This can be done by ensuring that waiver is at the discretion of the lender and that the bond is subject to both seizure by the lender’s creditors and is enforceable against the borrower through the lender’s estate if the lender is during the term of the Loan dies.

Note refinancing.

After all, customers with existing borrower’s note loans can benefit from these record-low interest rates through borrower’s note refinancing. If the terms of the original loan allow early repayment of the promissory note at any time without penalty, the lender may be able to reissue a replacement promissory note that takes advantage of that lower interest rate.

Summary.

Intra-family promissory notes can be an effective tool for transferring wealth to a family member in a tax-efficient manner. Given the current AFR, it’s a good time to consider whether this strategy is right for you.

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