November 28, 2020

Volume X, Number 333

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Intra-family Loans: A Simple Yet Effective Estate Planning Tool

An intra-family loan is a basic estate-planning technique which has a very low transaction cost. Under rules set forth in the Internal Revenue Code, it is possible to make loans to family members at lower rates than those charged by commercial lenders without it being deemed a gift. As discussed below, the lender, usually a parent or grandparent, must charge interest in order to avoid making a gift to the borrower. However, this interest rate may be as low as 1.18% for a loan for a term of three to nine years, with interest paid annually, made in August 2016. The lender can also structure the loan as a balloon note meaning that the borrower pays only interest during the term of the loan and only repays the principal at the end of the term.

Economic Benefits of Intra-family Loans

If a parent makes an interest-free loan to a child or grandchild, the Internal Revenue Service will treat the foregone interest as a taxable gift. In order to prevent the IRS from treating a part of the loan itself as a gift, the parent must charge a certain minimum interest rate, which is known as the applicable federal rate ("AFR"), which the Treasury determines every month. To the extent that the interest charged on the loan is lower than the interest calculated with the AFR, that amount will be imputed income to the parent, even though the parent does not actually collect it. Furthermore, the IRS will treat that amount as a gift to the child, which would require the filing of a gift tax return. However, if a parent establishes a bona fide creditor-debtor relationship with adequate stated interest, the intra-family loan will not be characterized as a transfer subject to the gift tax.

Intra-family loans create an opportunity to shift wealth from one family member to another family member, usually a child or grandchild, if that child or grandchild can earn a greater return on the amount borrowed than the AFR. The minimum interest rate required to be used depends on the term of the loan, and the compounding period. In August 2016, if interest is paid annually on a loan, the AFR for short-term loans (demand loans and loans for up to three years) is 0.56%. The AFR for mid-term loans (loans from 3-9 years) is 1.18%, and the long-term AFR rate for loans over 9 years is 1.90%. To the extent that a child or grandchild is able to earn a higher rate of return on the borrowed funds than the interest rate being paid, he or she is able to keep the excess without any gift taxes being paid.

For example, if a parent makes a nine-year loan to a child of $2 million, the loan will be a successful estate planning tool if the child can earn over 1.18% with the money borrowed. If the child invests the $2 million for the nine years at an 8% annual rate of return, he or she will have about $3,998,008 at the end of the loan, and will only have to repay his or her parents $2,222,706 throughout the course of the loan. Therefore, the child is entitled to keep the difference of $1,775,302 without any gift tax consequences. If the parent was going to make the same investment that the child made anyway, the risk to the family as a whole has not changed and the loan was a successful way to transfer wealth in the next generation.

Other Benefits

Outside of a wealth transfer concept, intra-family loans may also be more beneficial than third party loans because they allow the total interest expense paid over the course of the loan to stay within the family rather than being paid to a bank. In addition, an intra-family loan can allow children who have poor credit history to buy a home or to start a new business. Furthermore, it allows families to avoid the normal expenses incurred with loans, such as administrative costs, closing costs and appraisal fees. Also, if a child wants to pay off the loan early, the terms on the loan can be structured so that there are no prepayment penalties.

The amount of savings for children who are looking to buy a house can be significant. For example, according to Freddie Mac, the average bank rate for a 30-year fixed mortgage rate is currently 3.45%. A $500,000 mortgage at 3.45% would require one to pay $2,231 a month. However, a mortgage at the long-term AFR for August 2016 (1.9%) would only require one to pay $1,823 per month. Therefore, a child would save about $408 per month and about $4,896 per year if a parent loans him or her money to buy a home.

Additional Tax Benefits

The IRS allows any individual to make a gift to another person free of the gift tax each year up to the amount of the annual exclusion, which is currently $14,000. In addition to the annual exclusion, every person is allowed a $5,450,000 lifetime exemption from the gift tax. Therefore, even if an individual gives more than $14,000 to a single person in a given year, the gift amount which is above $14,000 will not be subject to tax unless the individual has already given $5,450,000 in taxable gifts throughout his or her life.

Because intra-family loans are not gifts, they do not count towards an individual's lifetime gift tax exemption. Therefore, even if an individual has used up all of his or her $5,450,000 lifetime exemption from the gift tax, he or she can still make a loan to a family member without paying gift tax. Furthermore, a grandparent can make a loan to a grandchild without being subject to the generation-skipping transfer tax.

In addition, an intra-family loan can be used to take advantage of the $14,000 annual exclusion. A parent can forgive up to $14,000 per year per family member (and up to $28,000 if a married couple splits the gift) without any adverse gift tax consequences. However, the parent will have interest income in any year in which interest is forgiven.

Conclusion                                                                                                                                        

An intra-family loan can be used as a simple and effective wealth transfer device. Such a loan is a successful estate planning tool if a family member earns a higher return on the money borrowed than the AFR, thus today's low AFR presents an opportunity to lock in a low interest rate on an intra-family loan.

© 2020 Proskauer Rose LLP. National Law Review, Volume VI, Number 212
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About this Author

Albert W Gortz, Proskauer Rose Law Firm, Personal Planning Attorney
Partner

Albert W. Gortz is a Partner in the Personal Planning Department and has been with the firm since 1970 and in the Florida office since he opened it in 1977.

561-995-4700
George D Karibjanian, Proskauer Rose Law Firm, Personal Planning Attorney
Senior Counsel

George D. Karibjanian is a Senior Counsel in the Personal Planning Department, resident in the Boca Raton office. George is Board Certified by the Florida Bar in Wills, Trusts & Estates and is a Fellow in the American College of Trust and Estate Counsel.

561-995-4780
David Pratt, Personal Planning Attorney, Proskauer Rose Law Firm,
Partner

David Pratt is a Partner in the Personal Planning Department and head of the Boca Raton office. His practice is dedicated exclusively to the areas of trusts and estates, estate, gift and generation-skipping transfer, fiduciary and individual income taxation and fiduciary litigation. He has extensive experience in estate planning and post-mortem tax planning. He has been asked to serve as an expert witness on several occasions, and has been referred to as a “seasoned trusts and estates lawyer” in a Florida Third District Court of Appeals Opinion

561-995-4777
Mitchell M Gaswirth, Proskauer Rose Law Firm, Tax Attorney
Partner

Mitchell M. Gaswirth is a Partner in the Tax Department. His practice focuses primarily on income, gift and estate tax and related business planning. Mitchell counsels individuals, entrepreneurs and business entities in connection with the various income and other tax issues which arise in sophisticated business transactions.

310-284-5693
Andrew M Katzenstein, Proskauer Law Firm, Personal Planning Attorney
Partner

Andrew M. Katzenstein is a Partner in the Personal Planning Department in the Los Angeles office where he assists high net worth individuals, companies and charitable organizations with all aspects of tax and estate planning. He focuses his practice on tax planning matters, which include estate, gift and generation-skipping tax planning, as well as income tax of trust planning, probate and trust administration matters, resolving disputes between fiduciaries and beneficiaries, and charitable planning

310-284-4553
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