Intra-Family Loans

     Clients often ask how they can assist family members and pass wealth to them without giving up their money. One strategy that accomplishes all of these goals is to engage in intra-family lending. An intra-family loan allows parents to loan money to a child for a specific amount of time at a specific interest rate. For example, recently a client of mine decided to lend $100,000 to her son and daughter-in-law to purchase a new, larger residence to accommodate their growing family. They set up an intra-family loan and documented it in writing with specific repayment terms. The son and daughter-in-law purchased an asset they could not otherwise afford and the client will get an annual interest payment as well as a return of her principal.

     A benefit of these loans as opposed to a bank loan is the ability of parents to charge a lower than market rate of interest. The Internal Revenue Service regulations require that the interest rate of the loan, known as the Applicable Federal Rate (AFR), equal a minimum rate set by the IRS each month. The current AFR annual rate just 0.18% for loans of three years or less, 0.95% for loans of more than three but less than nine years, and 2.47% for loans of a longer duration.As long as the child can find an investment that pays more than the principal and required interest, the child benefits from the loan, and the parent has effectively transferred wealth to the child that he or she would not otherwise have had. As an added benefit, in the current economy a parent can benefit from this relationship as well if the parent charges an interest rate greater than what could be gotten at currently low bank savings rates.

     To avoid any future conflict, it is important that client’s document the loan's amount, term, interest rate and repayment schedule in a formal written contract. This is important not only to ensure a return of the parent's money, but also for protecting the client against an IRS claim that the transaction was a gift, not a bona fide loan. 

     While there is an initial presumption that money or property transferred by a parent to a child is a gift, not a loan. It is possible to overcome this presumption by presenting by proof that the parties intended to repay the loan and intended to enforce the collection of the debt. Courts have held that the existence of a written document evidencing the debt, the charging of a specific interest rate, the existence of a set repayment day, and proof of actual repayment of the loan are all criteria that favor the position of a transfer was a bona fide loan.

     As with all tax related strategies, clients should seek the advice of a qualified professional before engaging in an intra-family loan. Proper planning can provide benefits to both the borrower and the lender.

Alan Ferrara