Annual Gifts and Intra-family Lending

     In June we discussed the subject of intra-family loans, including the very low Applicable Federal Rate (AFR) for interest on such loans, with regards to parents who want to pass wealth to their children without giving up any of their own assets. Parents can also use a similar technique to pass wealth in the form of appreciable assets to a child who might otherwise squander gifts of cash. By tying annual gifts to the repayment of an intra-family loan, clients are able to assist spendthrift children while also not appreciably depleting their own assets.

     Currently a person can give $14,000 tax-free to any other individual every year. This means that a married couple can give $28,000 to their child and $28,000 to that child's spouse for a total gift of $56,000 each year. By combining intra-family loans and a plan of annual gifting it is possible for clients to loan their child money to purchase a new home, or other long-term asset, and use the annual gift to pay down the balance of the loan.

     For example, a client can loan their son $150,000 to purchase a new home (making sure to do so using a mortgage and the AFR for a three-year loan). At the end of each year of the loan, the clients write their son and daughter-in-law a check for the annual payment including interest and the son and daughter-in-law write a check back to the parents for the same amount. After the client’s check clears in the son’s account, the client cashes the son’s check, and the loan is paid for the year. The son and daughter-in-law get a home and the client gets to make a gift to their son without worrying that the gift will go to waste.

     In addition to documenting the loan, charging interest, and having a mortgage on the property, it is important when using this technique for the client to make an actual gift and for the child to write a check for the annual payment. Failing to do so creates the possibility that the IRS could determine that the child has taxable “Forgiveness of Debt Income” that can impact their income tax filing. As with any lifetime gift planning, it is important for clients to seek the advice of experienced professionals in order to minimize the chances of such unforeseen consequence.

Matt Ferrara