Intra-family loans offer many benefits to the borrower. They typically have better terms and an easier application process than a commercial loan, and because you’re paying back a family member, you have built-in flexibility in your loans. They aren’t just useful for borrowers, either – intra-family loans can be a useful estate planning tool.
They do, however, need to be used very carefully. You must be aware of the estate, gift, and income tax implications of these loans, and if you want the advantages of an intrafamily loan, you need to take measures to ensure that the IRS isn’t going to reclassify your loan as a gift.
The right approach to intra-family loans and estate planning varies based on your objectives for your wealth, your family, and your estate. This guide outlines the basics of intra-family loans.
Maximizing the Value of Intrafamily Loans
A loan can allow the lender to effectively give the borrower a larger gift than they could give them on their own without triggering the gift tax filing requirement or eroding their estate tax exemption. This happens when the lender gives the borrower a gift that they invest into a vehicle with a higher return than the Applicable Federal Rate.
How Intra-Family Loans Can Grow Wealth for Borrowers
Here’s an example. Imagine that the AFR is 2%, and you lend a relative money they put into an investment with a 4% return. The spread allows them to earn money on the loan. It effectively lets you give your family member a larger amount than you would otherwise be able to. You need to be reasonably certain, however, of the return on your investment.
The lender must report the interest they receive from a family loan as income. The borrower can deduct the interest if they use the loan for their business or as an itemized deduction if they’re paying off a mortgage loan to a family member. They cannot, however, deduct the interest when they use the loan for personal reasons, vehicle loans, debt consolidation, or investments.
This strategy can sometimes have unintended capital gains consequences for the borrower. The borrower will have to pay capital gains tax on the gains they make when they sell the investment. Their capital gains will be the proceeds of the sale minus the amount they invested.
Imagine, in contrast, that instead of doing an intra-family loan, the lender kept the funds and made the same investment. They left the investment to their family member in their will, and the family member enjoys a step-up basis when they inherit the investment. That means that when they sell the investment, they get to use the value of the investment on the day they inherit it to calculate their capital gains tax. This significantly reduces their tax liability in most cases.
The optimal strategy varies based on your situation. You need to determine how the intersection between interest income, gift tax implications, and the step-up basis affect the lender and the borrower. You may also want to consider the emotional implications the loan may have on family members and the potential friction it could cause.
Family Loans: IRS Rules
The IRS may view loans as gifts if the loan doesn’t meet the criteria to be considered a loan. A loan reclassified as a gift may lower your estate tax exemption and lead to unwanted estate tax consequences. You should therefore treat the loan the same as you would any other personal loan. Here are some elements to consider.
Separate Legal Representation
This is not an absolute necessity, but it can help, especially when you’re worried the loan will be more heavily scrutinized. Separate legal counsel also gives you two teams of people who can review the loan and ensure it hits your estate planning objectives.
The written agreement should outline the amount being borrowed, the interest rate, and the term of the loan. You can customize these loans around the borrower’s needs. You may delay the initial repayment on a loan for someone who borrowed the funds to start a new business, for example.
You, however, need to ensure that the terms are reasonable. The repayment term of the loan should seek to get the funds back into the lender’s hands but to protect the borrower, you should ensure that there isn’t a prepayment penalty. These penalties are disallowed in some places as well.
Applicable Federal Rate
You must charge at least the applicable federal rate when you lend money to a relative. The IRS sets this rate monthly, and there are different rates based on the term of the loan. Failure to charge at least this rate can have your loan reclassified as a gift. The IRS rules let you choose different compounding patterns, but the interest should at least compound annually.
Tax reporting helps to create a paper trail showing the legitimacy of the loan. The lender may want to issue a statement of interest paid to the borrower. The lender, of course, must also report the interest they have received as income.
Plans for Repayment
The IRS also considers the intent of the borrower and the lender. There needs to be a plan for repayment. Forgiving loans to family members is possible, but you may want to wait until the loan balance gets below the gift tax threshold. You can then forgive the remainder of the loan without creating a filing requirement.
These elements can prevent the IRS from assuming that your loan was really a gift. You should also consider what will happen to the loan if the lender dies. The will may require repayment to the state, or it may forgive the loan. The reclassification often occurs when the estate tax return from the lender is filed. This underscores the importance of firming these details at the beginning.
Get Guidance on Intra-Family Loans from Bogart Wealth
We can help you maximize the value of intra-family loans so that they help rather than hinder your estate planning efforts. Bogart Wealth is committed to helping you preserve your wealth so that you can pass it on to the next generation — to learn more, contact us today.