Intra-Family Loans: The Family Bank

Intra-family loans are a way to help children or other family members finance major purchases at an advantageous interest rate. They’re also a good way to transfer wealth with a minimum of tax consequences for you or your heirs.

Intra-family loans come with interest rates that are usually lower than those through commercial lenders. They can be very helpful to children buying a new home, car, or buying into the family business. The key thing to remember is that it is an actual loan—not a gift. The child must pay the loan back.

Loan Rate: The Applicable Federal Rate (AFR)

Intra-family loans are loans between related parties. These loans 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. There you’ll see that the October 2018 monthly AFR for a long-term loan of ten years or more, is 2.95%. Compare this to the current national average mortgage rate of 4.89% for a 30-year fixed rate loan.2

Once the loan is in place with today’s AFR, it is locked in for the term of the loan—which could result in thousands of dollars in savings for the child.

Loan Structure

The IRS presumes that a transfer of money to a family member is a gift, unless you as the transferor can prove you received full and adequate consideration.3 You will need to demonstrate that a creditor-debtor relationship was in place at the time of the loan.

The following items can help make an intra-family loan official and keep it from being treated as a taxable gift: 4

  • A signed promissory note
  • A fixed repayment schedule
  • A fixed interest rate at least equal to the AFR for the month in which the loan is made
  • Requested collateral from the borrower
  • Repayment is demanded
  • Records 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 solvency
  • No plan to forgive the loan

The Family Bank

If the senior family members have the financial ability to provide a loan to a child, should they do it? Some of the advantages to the family are as follows:

  • A family lender may earn a greater rate of interest on her cash through the loan than from the bank.
  • The money stays within the family rather than paying an outside bank.
  • A family lender can help a child without giving him or her money, preserving the child’s self-sufficiency and ability to learn to manage debt.
  • The child’s credit rating may not allow him or her to obtain a loan from a retail lender. An intra-family loan does not get reported to credit bureaus.
  • The child may save on closing costs with an intra-family loan as compared with a retail lender.
  • There is no longer a tax deduction for home equity loan interest if it is used for purchases other than home improvements. This makes low-interest intra-family loans for a car or a boat a financially beneficial option for the child borrower.
  • If the child defaults on a bona-fide, documented loan, you can take a deduction for non-business bad debt if you can prove that you tried to collect the debt. The debtor should make a written statement indicating inability to pay and the reason.5

Some disadvantages and cautions with intra-family loans include:

  • 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.
  • If the family lender really doesn’t want to be repaid and doesn’t plan to collect on the loan, a taxable gift to the child may make more sense and would alleviate the administrative burden at the outset, during the loan, and at the point when the loan is forgiven.
  • If the child’s financial needs can be satisfied through annual exclusion gifts, which are free of gift tax, the senior family member should consider making such gifts rather than setting up the cumbersome intra-family loan apparatus.
  • Loans to children for consumption purchases like a car or a boat may be inefficient for the family wealth. The interest is not tax deductible to the child and is taxable to the parent-lender, thus generating taxable income for the family at a presumably high tax rate.6
  • The child could run into financial or personal issues where they are unable or unwilling to pay the loan back. This could cause family discord and may result in the loan becoming a taxable gift.

Many advisors recommend a family meeting as a prerequisite to becoming the so-called family bank. In the meeting, the parents have an opportunity to present their goals for the family and the family money, their values, and why and how they plan to provide support to children and grandchildren, along with any conditions. In my experience, these meetings usually work best when facilitated by the parents’ advisors to keep the discussion at a professional level and keep the focus on the parents’ wishes rather than the child’s needs or desires.

Estate Tax Benefits

Several common wealth transfer (or “estate freeze”) strategies take advantage of low AFRs, such as intentionally defective grantor trusts (IDGTs) and grantor retained annuity trusts (GRATs) where an asset is transferred to a grantor trust for the consideration of a loan or annuity payment. Charitable lead trusts (CLTs) also use the AFR to calculate the charitable income tax deduction going to the grantor in the year the trust is funded, as well as the gift-taxable remainder interest if it goes to heirs.

These strategies allow you to transfer an asset at its current (or discounted) value that is earning or appreciating more than the applicable federal rate out of your estate and avoid estate tax on the net gain. You transfer the asset at its value today, thus freezing the value that may be included in your estate, and the net appreciation over the rest of your life is outside of your taxable estate. Each strategy has its appropriate use; to find out more, please contact your James Moore advisor or HKFS financial planning consultant. These strategies can be modeled to show how they may be of benefit.

Concluding Remarks

Applicable federal rates have been going up over the past year along with overall interest rates, making intra-family loans an appealing option. Many high net worth families have taken advantage of the exceptionally low rates in the past few years, and while rates of under 2% are unlikely to return in the foreseeable future, the current rates can still provide a significant savings over commercial lenders and should be considered by families with significant wealth.

All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a James Moore professional. James Moore will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.

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1 “Applicable Federal Rate – AFR,” Investopedia;
2, 10/03/2018;
3, 4 “Estate Planning Issues with Intra-Family Loans and Notes,” Steven R. Akers, Philip J. Hayes, p.13;
5 “Family Loans: Does the IRS Care if I Lend My Kids Money?” Sally Herigstad, TaxAct.Blog;
6 “Estate Planning Issues with Intra-Family Loans and Notes,” Steven R. Akers, Philip J. Hayes, p. 3;