After his recent discovery of the power of charitable remainder trusts (CRTs), fictional Wealthpreneur Patton Thorne is interested in learning about a new tax planning technique: intrafamily loans. In a recent tax planning meeting, Patton’s CPA explained an intrafamily loan is a financial arrangement between two family members where one is lending and the other is borrowing.
But Patton realizes loaning money to family members has both income tax and wealth transfer tax implications. The most effective intrafamily loan strategy for him depends on his family’s circumstances and the prevailing level of interest rates.
Patton’s CPA pointed out that intrafamily loans may be used by the borrower for many purposes, such as:
- purchasing ownership of a family business
- purchasing a residence
- funding a business venture
- investing in other assets
- paying down high-interest debt
Wealthpreneur Lesson
Polonius Was Not a CPA!
In William Shakespeare’s play Hamlet, Polonius gives this advice to his college-bound son Laertes: “Neither a borrower nor a lender be.”
In some cases, this 1600s wisdom still applies today. But being a borrower or a lender through an intrafamily loan may be an advantage for you and your family!
AFR adventures
Patton and his CPA agree that avoiding negative federal tax consequences is a must! As a lender, Patton must charge an interest rate no lower than the appropriate applicable federal rate (AFR) for the month in which the loan was made. The AFRs are redetermined by the IRS monthly and vary based on the term of the loan. These are the AFR rates with semi-annual interest compounding for the month of September 2024.
Everyone wins
When Patton’s daughter, Nicole Thorne, hears about intrafamily loans, she thinks about her existing home mortgage. She and her husband purchased their dream home in October 2023, when 30-year mortgage rates reached a peak. The interest rate on her $750,000 mortgage loan is a whopping 7.79%!
Nicole’s monthly mortgage payment is $5,394. Since the current long-term AFR is 4.32%, if Nicole refinanced her mortgage with a 30-year loan from her father, her monthly payment would be $3,720. She could save $1,674 per month for a total of $20,088 in annual savings! Nicole knows Patton has a large cash balance invested in 3-year Treasury securities that earn 3.79%. Her idea would save her money while making more money for her father!
Patton loves Nicole’s idea of a home mortgage refinance loan. He trusts her more than those politicians to repay his loan plus interest!
Thwarting the death tax
According to their CPA, the Thornes can benefit from intrafamily loans in more ways than one. When interest rates are very low, intrafamily loans can accomplish substantial tax-free wealth transfers for families with estates subject to the wealth transfer tax. Patton is shocked that his family wealth could be subject to a 40% “death tax” each time assets are transferred from one generation to another!
The mechanism of this death tax benefit is simple rate arbitrage. Parents can loan money to their children at a low interest rate and the children can invest the borrowed money at a higher rate. The difference represents a death-tax-free increase in wealth for the children!
All in the family
Patton and Nicole have been evaluating several potential cash flowing real estate investment opportunities. Now that she knows about intrafamily loans, Nicole asks Patton to make her another loan she can use to fund an investment in their family real estate holding company.
Patton agrees to loan Nicole $1 million. In exchange, he receives a 20-year, interest-only balloon note at the long-term AFR of 4.32%. Nicole invests the borrowed money in their family real estate investment vehicle and achieves a targeted after-tax return of 20%.
At the end of the 20-year period, Nicole’s investment will be worth $38.3 million. The amount paid on the loan will only be about $2.3 million. (For simplicity of calculation, this assumes all interest would be paid at maturity.) The difference of $36 million will be a death-tax-free transfer of wealth!
4 Benefits of Intrafamily Loans
- They provide more flexibility than traditional commercial loans.
- The terms of the loan can be structured to accommodate the borrower’s circumstances and needs.
- The minimum AFR rate, which is often lower than the rate on comparable loans, can be charged regardless of the borrower’s creditworthiness.
- You can transfer wealth to family members without reducing your lifetime death tax exemption.
The IRS devil in the details
Your intrafamily loan must be bona fide to be respected by the IRS. You must observe all loan formalities as if the loan was between unrelated parties. The IRS generally assumes any transfer of money between family members is a gift, which is subject to tax at the same rate as the death tax. To prevent this treatment, you need loan documents that reflect the lender’s and borrower’s intent for the cash transfer to be treated as a loan.
Attorneys typically recommend you sign a promissory note that follows state-specific rules and includes the following information:
- payment structure of the loan (including the interest rate, the schedule of principal and interest repayments, and the maturity date)
- security to ensure repayment of the loan
- prepayment penalty applicability
- terms for loan forgiveness
Look before you loan
Intrafamily loans can be a tax-efficient way to transfer wealth to family members, but implementing one takes careful consideration and planning. Depending on how the borrower will use the loan proceeds, various tax planning considerations may need to be addressed.
