A. An intrafamily loan rather than a gift can be attractive if you’re not ready to part with your wealth — for example, because you’re concerned about having enough money to fund your retirement or you feel that your children aren’t ready to handle the responsibility. Intrafamily loans allow you to provide family members with financial support while hanging on to your “nest egg” and encouraging your children to be financially responsible.
When you lend money to family members, it’s important to charge interest at the applicable federal rate (AFR) or higher. Otherwise you’ll trigger unintended income and gift tax consequences.
The key to transferring wealth with an intrafamily loan is the borrower’s ability to take advantage of investment opportunities that offer relatively high returns. In other words, the borrower essentially receives the “spread” between the investment returns and the loan interest being paid — free of gift and estate taxes.
Average AFRs, which are adjusted monthly, have been low, perhaps making it easier for a borrower’s investments to outperform the interest rate on a loan. AFRs vary depending on whether the loan is short term (three years or less), midterm (more than three years but not more than nine years) or long term (more than nine years). They also vary depending on how frequently interest is compounded.
Keep in mind that the loan balance is still included in your taxable estate. Even if you die before the loan is paid off, the borrower generally must repay the loan to your estate, although an intrafamily loan can be structured to provide that the loan will be forgiven if you die before it’s paid off.
Understand the risks
The biggest risk, of course, is that the invested funds will fail to outperform the AFR. If that happens, your child (or other borrower) will have to use his or her own funds to pay some or all of the interest — and, if he or she experiences a loss on the investment, even some of the principal. In other words, instead of transferring wealth to your child, your child will transfer wealth to you. As noted above, however, low AFRs help minimize this risk.
There’s also a risk that the IRS will challenge the loan as a disguised gift, potentially triggering gift tax liability or using up some of your lifetime exemption. To avoid this result, you must treat the transaction as a legitimate loan. That means documenting the loan with a promissory note and adhering to its payment and enforcement terms. So, for example, if your child is unable to make a payment, you should make a genuine effort to collect the funds from the child.
Avoid the temptation to make no-interest loans to family members (or loans with interest below the AFR). If you do, you’ll be subject to income tax (with certain exceptions for smaller loans) on imputed interest — that is, the excess of the AFR over the interest you actually collect. So, you’ll be taxed on interest that you didn’t receive. In addition, the imputed interest will be treated as a taxable gift made by you to the borrower.
An important decision
Determining how best to transfer your wealth to loved ones takes much thought. Whether making an intrafamily loan is the right strategy for your situation — or giving gifts makes more sense — is a question you must consider before taking action. Discuss your options with your tax and estate planning advisors.