by Kelly Ritrievi, Trust Services, Sanibel Captiva Trust Company
Your neighbors – let’s call them the “Conners-” own a successful restaurant supply business and are nearing retirement. Their son has worked in the business for more than 20 years and is well known among clients. But his children are in private school, and he has a home mortgage. Taking out another loan to buy the business may be burdensome. The Conners’ youngest daughter, a schoolteacher, hopes to buy a townhouse in the city but cannot qualify for a loan because of her modest salary and poor credit. These scenarios could have a common solution: The Intrafamily Loan.
An intrafamily loan can be an ideal strategy for both borrowers and lenders alike, if structured properly. Intrafamily loans are made at the minimum interest rate allowed by the IRS for private loans – the Applicable Federal Rate (AFR) – to provide borrowers with a lower lending rate when compared to other private lenders. The current AFR of 3.14% on a long-term loan compares very favorably to the current national average of around 6% for a 30-year mortgage. With an intrafamily loan, there is no need for credit approval, and you (the lender) get to establish the payment terms for the loan.
For families like the Conners, the intrafamily loan can enable family members to meet personal goals. Parents can make a direct loan to a child or, if the request is large, a loan to a trust. Regardless of whether an individual or a trust receives the loan, diligence is required in collecting and tracking payments to ensure that the loan does not look like a gift in disguise, potentially triggering a gift tax and reducing the lender’s lifetime exemption.
An intrafamily loan can be designed to fit individual circumstances. For borrowers like the Conners’ son, this could mean using income from the family business to repay the loan if the rate of return from the business is greater than the interest rate on the loan. If the loan is made to a trust, the trust becomes the borrower, which relieves the individual from repayment obligations. If the trust is a grantor trust, the individual may avoid paying taxes. In the case of the Conners’ daughter, her limited cash flow might necessitate setting up an interest-only loan with a final balloon payment. Or her parents could make annual exclusion gifts to her to use for repayment or to excuse the loan. In any case, there are multiple strategies for structuring an intrafamily loan to help ease the debt burden, ensure repayment, and comply with IRS guidelines.
Complying with the IRS, however, is crucial. Borrowers may be able to deduct the interest if they use the loan to make investments or buy a home or business but can’t deduct interest if the loan is used to pay off a credit card or for personal consumption. Lenders may likewise have to declare the interest income on their tax return. And if the lender charges less than the AFR rate, the IRS may deem the loan to be a gift that is subject to estate exemption limits.
Consider family dynamics before deciding to lend money. Relationships can be strained when a loan is made to one child to the exclusion of others. Parents should also be conscious of their own liquidity needs before making a loan. A defaulted loan could cause you to make budget or lifestyle changes and create other estate and income-tax consequences. So, while the transfer of money between family members can be a win-win, it is not without its pitfalls.
This is not an exhaustive account of the structure and function of intrafamily loans. Discuss your situation with your legal and tax advisors as well as with family members before deciding whether this strategy is right for you.