Coordination of Intra-Family Loans Can Achieve Estate Planning Goals

The continuing era of low interest rates has benefited many borrowers, but it has wreaked havoc for many families concerned about wealth management. In years past, aging parents might have turned to fixed income investments to provide relatively safe and solid retirement income. Currently, however, bond ownership comes with at least two problems:

  • Bonds currently offer minuscule levels of interest income, and
  • If and when rates do rise, the bond’s value will similarly fall.

More and more these days, estate-planning experts are pointing out that there are ways to take advantage of the low interest rate climate. One is by making intra-family loans. Under this arrangement, the client – often one or both parents – loans money to a younger family member – child or grandchild – at a rate less than that which would be charged by a commercial lender. Structured correctly, the IRS does not consider the transaction to be a gift. The child or grandchild gets a boost, either with the infusion of cash that can in turn be reinvested in an asset likely to appreciate, such as personal residence or business. Moreover, the family member enjoys the favorable interest rate.

Intra-Family Loans Must Be Appropriately Crafted

The IRS usually treats interest-free loans as gifts, but properly structured, the transaction will be treated as a true loan. In order to pass IRS scrutiny, the loan should have the following characteristics:

  • Call for the payment of interest at a rate at least equal to the “applicable federal rate,” a rate published by the Treasury Department each month. As of September 2016, the interest rate for a loan of three to nine years could be as low as 1.33 percent.
  • The transaction must be evidenced by a promissory note that calls for the payment of the stated interest rate and which requires repayment of the principal amount loaned.
  • If at all possible, the note should be secured. For example, if the proceeds are being used to purchase a house, the note could be secured by a mortgage. An added advantage here: The borrowing child or grandchild can deduct the home mortgage interest.

How is this an Estate Planning Tool?

If the loan has to be repaid, one might wonder how is the intra-family loan an estate-planning tool? Consider the following hypothetical:

Assume the parent makes a nine-year loan to a child of $1 million. Provided the borrowing relative can earn more than the 1.33 percent AFR, the loan will transfer wealth to the borrower without tax liability. For example, if the family borrower invests the $1 million for the nine years at a 6 percent annual rate of return, he or she will have approximately $1,690,000 at the end of the loan, and will only have to repay his or her parents $1,119,700 throughout the course of the loan. Therefore, the child is entitled to keep the difference of $570,300, without any gift tax consequences.

If the parent was going to make the investment anyway, the risk to the family has not changed and the loan was a successful way to transfer wealth in the next generation.

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The attorneys at Romano & Sumner, LLC have more than 20 years of combined experience providing expert legal assistance to clients in all types of wealth management and estate planning. At Romano & Sumner, we never use a cookie cutter approach. We listen to you and offer multiple alternatives that will help you maneuver through the complicated tax and legal arena. We pride ourselves upon our professionalism and client service. We keep our clients informed, returning your calls within 24 hours. We’re ready to assist you as you make the important decisions that affect your family. Call us at 281-242-0995 or complete our online contact form.

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