Other Planned Gifting

While gifting strategies can involve millions of dollars and extensive family businesses, they can also take a much smaller form, allowing parents to make gifts to children to assist in the purchase of a home or other investment opportunities. Coupled with intra-family lending strategies it is even possible to greatly exceed the annual gifting limits.

Eric and Fran have two children, Georgia and Haley, with whom they are very close. Circumstances had led to the daughters, along with their husbands, living a significant distance from Eric and Fran. A significant factor in this situation was the high cost of property near Eric and Fran’s home, keeping the daughters in their young marriages from affording to live closer to their parents. Eric and Fran had done fairly well for themselves and have the flexibility to assist their children, but want to do so in a way that does not completely provide the daughters and their husbands with a handout. 

Through a series of discussions with us, each other, and a realtor, Eric and Fran located a large parcel of land for sale in an area that was centrally located for all three families. They then proposed that if the daughters and their husbands were willing to build a home on the property, Eric and Fran would purchase the land and divide it into three parcels so that the family could all be close together. This land division would take the form of a gift where Eric and Fran would each give each of their daughters and each husband a gift of interest in the land on December 31st and January 1st of the following year. This complex gift allowed Eric and Fran to each give $14,000 of value to each of their daughters ($28,000 from both parents together) plus the same amount to each son-in-law. They then repeated the gift the next day so that within the span of twenty-four hours Eric and Fran had effectively gifted $112,000 in land to each of their children. 

While this initial gift allowed Eric and Fran to bring their family back together, it was only half of the plan they eventually put into place. Once Georgia, Haley, and their husbands owned the land, there was still the matter of building houses. After working with builders and architects to create designs for all three homes, construction was set to commence.  Instead of funding the construction with a standard building loan, Eric and Fran had the means to loan each of their daughters the cost of construction. They did this much like a normal loan, documenting the whole process and including with the loan a mortgage on the property and residence, which insured that Eric and Fran would be repaid, and gave them a priority lien on the property in the event their daughters ever found themselves in financial dire straits. 

A significant benefit of this intra-family loan was the ability for Eric and Fran to use the IRS’s Applicable Federal Rate (AFR) as the interest rate for the loans, instead of using a standard bank rate. While bank rates at the time were relatively low, the AFR for a short-term (under three years) intra-family loan was under 1% annually. This allowed Eric and Fran to establish loans to their daughters that would save the daughters thousands of dollars in interest payments over the lifetime of the loan. The monthly loan payments were amortized over a normal 30-year period with a balloon payment at the end of three years, the intention being that the loans be “refinanced” at the three-year mark to pay the balloon payment and every three years thereafter to continue to take advantage of the very low short-term AFR. 

While all of these steps provided a great benefit to Georgia and Haley, Eric and Fran wanted to build in one more benefit to their daughters (and their sons-in-law). Each year after the creation of the loans, if each couple made all of their required payments on time and in full, Eric and Fran would make additional “gifts” to reduce the principal of the loan. These gifts are always less than the annual exclusion and therefore will never impact the couple’s lifetime exemption. Eric and Fran also like the idea that the future gifts are discretionary (and not guaranteed or required) and that they are not simply handing their daughters money that they will not fully appreciate. If Georgia, Haley, and their husbands follow through with their obligations in full (and Eric and Fran continue to make annual gifts), they will enjoy fully paid off homes in a burgeoning Michigan community in less than ten years, a significant advantage and one that will not incur any gift tax liability for anyone involved. 

We cannot state enough that this and every other strategy we discuss in this blog involve complex planning and should not be attempting without consulting experienced attorneys and other advisors to ensure that expensive errors to not occur. 

Matt and Al

The Benefits of Intra-family Lending

With this blog, we return to the subject of gift planning. Clients like the idea of reducing taxes with gifting, but the problem is they actually have to give away an asset. When the client expresses an interest in gift planning, We ask them "What amount of assets do you have to own to feel comfortable giving away something?" The answer is usually "just a little bit more!”

     A common issue that arises when we discuss gift planning with a client is the desire to assist their children without giving up control of the assets. One strategy used in this situation, which allows clients to provide funds for family members' use while still protecting the client’s own interests, is intra-family lending. 

     An intra-family loan works much like any other loan, parents loan money to a child for a specific amount of time and at a specific interest rate. For example, a client agrees to lend $200,000 to her son to help finance a business purchase. The son signs a promissory note with specific repayment terms and a mortgage on the new business as security for repayment of the loan. This intra-family loan allows the son to purchase a business he could not otherwise afford and begin securing his own financial future. The client, over time, will get an annual interest payment as well as a return of her principal. If the child's business earns more than the principal and required interest, the child benefits from the loan, and the client has effectively transferred wealth to her son that he would not otherwise have had. 

     While the annual interest payment and opportunity to run their own business are clear benefits to the client and her son, the benefits of an intra-family loan, as opposed to a bank loan, also include:

1. The parents' ability to set an interest rate far lower than any interest rate available through a bank. While the Internal Revenue Service regulations require that the interest rate of the loan equal a minimum rate set by the IRS each month, the current annual rate is just 2.19% for loans with a duration of more than nine years and significantly lower for shorter loans. If the parents desire, they can charge an interest rate greater than minimum rate but lower than current bank savings rates, increasing the parent’s benefit and still give a benefit to the child.
2. The parents give the child the opportunity to have access to an eventual inheritance much earlier, with much less risk. The parents can also assess the child's abilities to handle the money and perhaps modify the distribution provisions of their estate plan. 
3. In the event parents want to provide their child with an additional benefit, they can use their Annual Gift Tax Exemption to provide their children with the funds to reduce the principal of the loan, without the worry that the child will frivolously waste such gifts.

     To protect the client and avoid potential problems, it is important that clients document any intra-family 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.  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.

     Intra-family lending is a very useful technique for clients who want to provide gifts to their children, while retaining control of their own assets. 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.

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

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