Proactive planning with low interest rates using intra-family loans

Theresa Marx
April 29, 2020

Do you have loved ones you want to help, but aren’t ready to give away significant assets yet? Would you like to take advantage of the low interest rate environment and transfer wealth in a cost-effective way with minimal transfer tax consequences?

This is the fifth in a six-part series that focuses on proactive planning strategies in a volatile market.

The current economic conditions and market volatility have left many lacking confidence about the future.  Yet it is important, perhaps now more than ever, to continue to look for wealth planning opportunities and not lose sight of the things that matter most in life—which for many, begins with loved ones.  For those who are looking to engage in wealth planning while helping a loved one who is less financially secure than they were just a short time ago, one strategy that may help accomplish both goals is an intra-family loan.

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What is an Intra-Family Loan?

An intra-family loan is a loan between family members (or other loved ones) that typically carries an interest rate that is lower than commercial lending rates. These loans can be made directly to the borrower, or to a trust created for the benefit of the borrower.  Intra-family loans are often used to provide liquidity to the borrower—whether to help in a time of financial difficulty or to achieve a specific goal, such as purchasing a home or starting a business.  Furthermore, intra-family loans may instill a sense of responsibility in the borrower because, unlike an outright gift, the borrower must abide by the terms of the loan.

How an Intra-Family Loan Works

If the lender in an intra-family loan establishes a bona fide creditor-debtor relationship with stated interest at or above the applicable federal rate (AFR) published by the Internal Revenue Service monthly, the intra-family loan will be treated as a loan and not as a transfer subject to gift tax.  In order to establish the creditor-debtor relationship, the lender should strive to make the loan official with the creation of a promissory note, a fixed payment schedule and records of payments.  If the loan is for a large asset, such as a house, the lender should document the security or collateral (e.g., a mortgage).

A key feature of an intra-family loan is the interest rate because the AFR is generally lower than rates charged by commercial lenders.  If the borrower can earn a return on the borrowed amount greater than the AFR, then that excess appreciation accrues for the benefit of the borrower rather than the lender.  Further, intra-family loans allow the interest expense paid over the term of the loan to stay within the family and can allow the borrower to save on some of the ancillary costs of borrowing, such as administrative costs and closing costs.

Another benefit of intra-family loans is that they can be structured however the lender sees fit, as long as the interest rate is adequate and the loan is repaid. This means loans can be tailored to the needs of the borrower. For example, a loan could be structured with interest-only payments during the term of the loan and a balloon payment of principal at the end of the term, to allow the borrower to take full advantage of the maximum growth potential of the borrowed principal.

Using Intra-Family Loans in a Low Interest Rate Environment

Now may be an ideal time to make a loan to a loved one, because many asset values have declined and AFRs are currently at historic lows.  (In May 2020, AFRs will range from 0.25%-1.15%, depending on the term.)  If the borrower utilizes the loan proceeds to purchase a recovering asset that generates a return that is greater than the AFR, then the grantor will have effectively transferred any appreciation over the AFR to the borrower with no transfer tax cost.  Further, if the intra-family loan is being used for a specific purpose, such as a home purchase, then taking advantage of the historically low AFRs with an intra-family loan rather than a commercial loan can generate significant savings in interest payments for the borrower.

Anyone thinking of making an intra-family loan should carefully consider the impacts of making the loan on the lender, borrower and their wealth planning goals. In addition, if the lender and borrower think that loan repayment may be a concern in the future, they should carefully consider the potential consequences of the failure to repay before the loan is made. It is important to consult qualified experts for income and transfer tax advice and to determine whether an intra-family loan is the best planning option.

Learn more about Lifetime Gift Planning.

Proactive Planning During a Time of Uncertainty and Volatility
Part 1: Proactive Planning in Volatile Markets With Grantor Retained Annuity Trusts (GRATs)
Part 2: Proactive Planning in Volatile Markets with Roth Conversions
Part 3: Proactive planning with low market values using Spousal Lifetime Access Trusts
Part 4: Proactive planning with low market values using a sale to a Grantor Trust
Part 6: Proactive planning with low market values using gifts