In today’s high interest rate environment (with current AFR sitting well over 4%) many people are turning to intrafamily loans to assist with major investments as opposed to commercial lenders.
Whether it’s a parent helping a child buy their first home, a grandparent helping a grandchild with a new investment opportunity, or a sister helping a brother when times get tough, helping a loved one is important to many people.
At higher levels of wealth, these types of requests may not be infrequent. Having the cash on hand could make you a likely target for these types of requests from family members in need, so it’s important to consider the best steps forward for this type of arrangement.
Too often, however, family loans are informal. If they are too informal, then those loans can have unexpected tax consequences or otherwise disrupt your financial plan. Here are several things to consider when lending more than $100,000 to a family member.
Make Your Intrafamily Loans Legal
When lending money to a family member, it is important to have a written loan agreement that documents the following terms of the loan:
- The legal names of each party (the lender and the borrower)
- The loan amount
- When the loan was made and when it will be paid back
- Interest rate charged on the loan
- Whether the loan payments made by the borrower will be interest only or principal and interest
The lender has a lot of flexibility with the terms, but there are guidelines to the minimum amount of interest charged on loans between family members for the loan not to be reclassified as a gift by the IRS.
That minimum rate is based on the Applicable Federal Rate (AFR) the IRS publishes each month. The AFR can be found on the IRS website. AFR rates change every month to keep up with the economy and you will generally use the appropriate revenue ruling based on the month the agreement is made.
There are different rates for loans of different durations (short-term, mid-term, or long-term) and with different compounding periods (annual, semiannual, quarterly, or monthly). Short-term loans are 3 years or less; mid-term loans are between 3-9 years; long-term loans are longer than 9 years.
Unless an exception is met, the interest rate charged on the loan is considered interest income to the lending family member and must be included on his/her tax return. If no interest is charged, or an interest rate below the AFR is charged, the AFR interest is still considered income and taxable to the lending family member.
The difference between what was actually received and what is taxable income is called imputed interest income or phantom income.
For example:
- Mom and Dad lend Son $500,000 on September 5, 2023 with an interest rate of 2%.
- Son pays Mom and Dad $10,000 on September 5, 2024..
- The AFR for September 2023 on a mid-term loan is 4.19%.
So, even though Mom and Dad only received $10,000 of interest in 2024, they are required to report $20,950 as interest income on their tax return. Why? The $10,950 not actually received is phantom income.
In addition to having taxable income that was not actually received from charging an interest rate below the AFR, the lending family member is also assumed to have made a gift of the imputed interest to the borrowing family member. That’s a double whammy!
In most cases, the annual gift tax exclusion ($18,000 per person or $36,000 per married couple in 2024) is sufficient to prevent the gift from having any tax consequences, but with sizable loans the gift tax exemption may not fully cover.
On the borrowing family member’s side, they may be able to deduct the interest paid in the following circumstances:
- Money borrowed for real estate purchase – if the intrafamily loan is recorded as a mortgage against the property, the interest might be deductible as mortgage interest on the borrower’s tax return.
- Money borrowed for investment purchase – interest might be deductible as investment interest expense as a business expense or itemized deduction.
When The Loan is Deemed a Gift
If the borrower does not make interest payments on a regular basis, the IRS could view the loan as a gift. What are the tax implications of having a loan categorized as a gift instead of a loan?
A loan of the annual exclusion amount or less is exempt from any gift tax consequences provided the lender is not making other gifts to the borrower. Each lender (Mom and Dad each being their own lender) can give $18,000 to any single person in 2024 (Son) and the gift has no tax consequences. Therefore, Mom and Dad could give Son up to $36,000 in 2024 and not need to file a gift tax return.
A gift is also deemed to be made when the borrower doesn’t pay the charged interest. In the example above, the imputed interest (difference between interest paid and AFR interest) of $10,950 is considered a gift. As long as Mom and Dad don’t make other gifts to Son that put them over the annual gift tax exclusion amount, there won’t be any gift tax consequences.
From the borrower’s perspective, they lucked out—no income or gift tax consequences on their end if the loan is deemed a gift.
What Happens If One Party Dies
If the lender dies, the lender should state in their will whether they want the loan repaid to his/her estate, forgiven and deducted from borrower’s inheritance, or treated some other way.
If the borrower dies without sufficient funds to pay the loan, the loan is deemed worthless and treated as a non-business bad debt. A short-term capital loss is allowed in the year the loan is confirmed it won’t be repaid; that might be the year of death or once the borrower’s estate is settled. The amount allowed as a loss is any outstanding interest and principal.
Other Intrafamily Loan Considerations
Outside of the legal considerations that need to be addressed when making an intrafamily loan, the lender should also consider other items such as funding the loan, cash flow impact, and family dynamic.
If the lender does not have enough cash to make the loan, what investments should be sold to generate the cash? Since the loan will be earning interest, similar to a fixed income alternative, should fixed income investments be sold and replaced with the loan as part of the lender’s portfolio? Selling investments to generate cash may result in capital gains or losses that could impact the lender’s taxes.
The lender should also recognize that having an intrafamily loan in their portfolio is less liquid than holding other types of fixed income, such as bonds, CDs, money market funds, etc. Therefore, the lender should analyze the impact this loan will have on their cash flow.
One final consideration to think about before lending to a family member is how the family dynamic could be impacted if the situation doesn’t go as planned. While the borrower will gain better financial knowledge by receiving a loan instead of a gift, what if the loan does not get paid back? At the onset, intentions are good for loan repayment, but life happens and if the loan does not get paid back, relationships could be impaired.
So, while we all like to help family members in a time of need, make sure you think through the details of any financial transaction both financially and relationally, clearly document the terms so both parties understand the consequences, and be prepared if it doesn’t go as planned.
If you are considering a substantial intrafamily loan, it may be best to consult with a tax advisor, as well as nail down your estate planning details before you enter into this agreement. Intrafamily loans are not ideal methods for larger generational wealth transfer goals, which may be better addressed through financial planning with a Wealth Management firm like Plancorp.
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