With current interest rates at near historic lows, and demand with traditional lenders at all-time highs, loans among family members, "intra-family loans," continue to be a popular means of assisting family members and keeping wealth within the family.
The basic principle of an intra-family loan is fairly straightforward – rather than borrowing money from a bank, a family member in need borrows money from someone else in the family, such as a child borrowing money from his/her parents.
A properly structured and managed intrafamily loan has many benefits, including
- Lower interest rates for the borrower compared to commercial lending rates
- Option to structure loan as interest only to reduce cash flow obligations to borrower
- Interest costs paid by the borrower stay within the family (possibly inherited in the future)
- No recipient credit checks or reporting
- No loan costs to the recipient
- Better rate of return than cash for the lender
An added benefit of intra-family loans, especially as a mortgage for purchasing a residence, is that some of the constraints of traditional loan underwriting are no longer an issue; for instance, family members don’t have to charge more for a child with a bad credit score, and can freely provide loans up to 100% of the purchase price without requiring a down payment. The loan could be for a primary purchase, a refinance, or a renovation, and can even be structured as a 2nd or 3rd lien against the house.
Of course, the caveat is that engaging in such strategies does create a genuine risk for the lender that the loan interest and/or principal will not be fully prepaid, so the family-member-as-lender should be cautious not to lend funds in a manner where a partial default by the family borrower could actually create financial distress for the family!
A Gift From Parents Or A Loan?
An important caveat to intra-family loans is that, to be acknowledged the IRS, they really must be loans, and not gifts.
The tax code permits individuals to gift up to $15,000 to someone else each year without incurring any gift tax consequences; this amount is called the annual gift tax exclusion. Families who wish to transfer more than $15,000 annually have avoided this limitation by transferring money as a loan, not a gift… and then simply forgive a portion of the loan interest and/or principal every year until the borrowed amount has been extinguished.
However, the IRS has scrutinized many of these transactions over the years, often with adverse conclusions. As a result, the tax code and case law have been woven together to formulate some guidelines about how to manage an intra-family loan so it is truly categorized as a loan, and not a gift.
Intra-Family Loan Tax Rules and Requirements
The key to intra-family lending is that, for the loan to be honored by the IRS, it must be treated as a bona fide loan, including loan terms at a “market” rate of interest, proper payments of interest and/or principal, and the formalities of proper documentation.
To apply a “market” rate of interest, the loan terms should specify an interest rate at least as high as the so-called “Applicable Federal Rates” (or AFR) which the IRS publishes on a monthly basis under IRC Section 1274.
There are three AFRs:
- Short-term loans of up to three years;
- Mid-term loans from three to nine years; and
- Long-term loans of more than nine years.
What’s notable, though, is that while the Applicable Federal Rates are considered “market” rates, to the extent that paying intra-family loan interest at this rate avoids gift treatment, they are still remarkably favorable rates.
Implementing Intra-Family Mortgage Loans
One of the biggest challenges for many families considering intra-family loans – particularly intra-family mortgages – is simply the administrative work and requirements to document the loan properly.
When the parents-as-lenders truly do intend the transaction as a loan (and not a disguised gift), they want to be certain that the borrower respects it appropriately and learns some financial responsibility. Alternatively, if the money is being loaned out from a family trust, the trustee will likely wish for the loan to be properly documented and recorded to substantiate that fiduciary obligations to manage the trust corpus responsibly are being fulfilled.
At a minimum, to avoid gift issues, a promissory note should be used to memorialize the arrangement. Further, interest received by the lender on the loan should be reported on a Form 1099-INT and on the lender’s income tax return, and if the loan qualifies as a mortgage, the interest should be reported to the IRS on a Form 1098.
Some other interesting solutions have also emerged, several companies that complete all of the required documentation, records the mortgage, helps to service the loan, and even issues the requisite IRS reporting forms, all for a fraction of the cost of a traditional mortgage loan origination fee.
Refinancing Intra-Family Loans
With the historically low interest rate environment comes an opportunity to refinance these intra-family loans at remarkably low rates. The two main benefits are reducing the cash flow outlay of the borrower, and possibly more importantly keeping wealth in the younger generation. When the current estate tax exemption sunsets in 2025, we can now expect to see a lower exemption. Lower interest rates on family loans will allow borrowers to shift even less money from younger generations to older.
The process to refinance is fairly straightforward, including a redrafting of the promissory note and acceptance by all parties.
Following are the August 2020 AFR Rates:
Sources: IRS.gov, David Wright Tremaine LLP, Michael Kitces