Intra-family loan as an estate planning vehicle
An intra-family loan is a fundamental estate-planning tool that has a low transaction cost. According to the Internal Revenue Code, you can lend funds to family members at rates that are lower than those charged by commercial lenders without the funds being considered a gift. The lender is generally a parent or grandparent, who is required to charge interest to the borrower. Otherwise, the loan will be deemed a gift.
If a parent were to make a loan to a child or grandchild, the IRS would consider the lack of interest as a gift. In order to avoid such treatment, the parent is required to charge a specific minimum interest rate, which is called the applicable federal rate (AFR). If the interest charged on the loan is less than the interest computed with the AFR, that amount will be deemed income to the parent, although the parent does not receive it. In addition, the IRS will consider that amount a gift to the borrower, thereby requiring a gift tax return to be filed. But if the parent makes a loan with sufficient stated interest, the loan will not be considered a transfer subject to the gift tax.
Intra-family loans provide a chance to transfer wealth from one family member to another. In most cases, the recipient is a child or grandchild, who must earn a higher return on the amount borrowed than the AFR.
Intra-family loans might also be more advantageous than third-party loans because they permit the entire interest expense to be paid during the term of the loan to remain within the family instead of being paid to a bank. Furthermore, an intra-family loan can give children who have poor credit history a chance to purchase a home or start a business. It also permits families to avoid the usual expenses affiliated with loans, including administrative costs, closing costs and appraisal fees. And if a child wishes to pay off a loan early, the terms of the loan can be designed such that there are no prepayment penalties.
Lenders should avoid forgiving the loan, and hold borrowers accountable for repaying the loan. If the loan is subsequently forgiven, the IRS will treat the loan as a gift, and the lender must use the gift tax exemption or pay out gift taxes at the highest rate of 40 percent. The borrower will be required to pay income taxes on the amount forgiven.