Estate Plan Lawyer in Ashburn Explains Intrafamily Loans
Intrafamily loans can be an effective strategy for families to transfer wealth to the next generation, but they also have potential pitfalls and risks that must be considered and mitigated. Basically, intrafamily loans can be an incredibly effective tool to help create capital for families and successfully maintain and build wealth for future generations, but they must be completed with rigorous attention to detail.
Navigating the IRS Tightrope Between a Loan and a Gift
If you are contemplating an intrafamily loan, it is critically important to adhere to the requirements set forth by the Internal Revenue Service (IRS). Why? Because failing to follow the IRS guidelines when completing an intrafamily loan could result in the federal tax authority considering your loan to actually be a gift.
Intrafamily Loan Requires Minimum Interest Rate
One of the key requirements set forth by the IRS for intrafamily loans is a minimum interest rate. This base-level interest rate must be applied to the loan. If the interest rate is below this minimum, you run the risk of the loan being deemed a gift for tax purposes.
The IRS has three tiers of “applicable federal rates” for different loan terms: short-term loans (i.e., loans with a repayment period of 0-3 years), mid-term loans (i.e., loans with a repayment term of 3-9 years) and long-term loans (i.e., loans with a repayment period longer than 9 years). You can find the most current applicable federal interest rates here.
How Intrafamily Loans are Commonly Used
Intrafamily loans can be used for a variety of reasons. For example, given the higher loan interests rates from banks, it is difficult for the younger generation to make the higher monthly payments. The intrafamily loan rates are lower than the banks and can give the kids some relief when trying to purchase a home. Loans are also often used to pay college expenses or to start a business.
In the business context, there are numerous benefits associated with using an intrafamily loan in regard to purchasing the family business from a parent. First, this type of loan can help create the needed cash flow in the form of note payments back to the seller. Second, such a loan can create liquidity for the purchaser to make the necessary note payments. Third, such a loan will help set a value for the asset being sold, meaning no additional appreciation in the business or partnership is created in the estate of the sellers, according to a great Forbes.com article.
Example of How an Intrafamily Loan Works
Let’s say one of your children recently got married and is looking to settle down. You want to offer them an intrafamily loan for the purchase of a home. The current applicable federal interest rate for a long-term loan is 4.02 percent (as of March 2023). The current national average interest rate for a 30-year fixed mortgage is over 7 percent. As you can see, the intrafamily loan offers an arrangement that can save your child a significant amount of money over the life of the loan. In addition, subject to itemization rules, your son or daughter could also deduct the mortgage interest.
Potential Pitfall of Intrafamily Loans
One of the biggest pitfalls associated with intrafamily loans is when such a loan is provided to one child but not others with the family. This often leads to acrimony and contention between siblings and between parents and their children. An effective strategy for avoiding this pitfall is being as transparent as possible and keeping all your loved ones in the loop. Offering an intrafamily loan to one family member versus another may even warrant a “family meeting” where the loan is discussed together and a clear explanation for the rationale behind the loan is made clear to all family members. During such a meeting, it could be emphasized that this is a loan and not a handout. The recipient is not being given a large sum of money. Rather, they are now on the hook to pay both the principal and the applicable federal interest rate.
Have Questions? Contact InSight Law Today
Intrafamily loans can be an effective tool to help maintain and build generational wealth, but such loans should be offered and used with care, both for your financial wellbeing and to mitigate the risk of intrafamily acrimony. If you want to learn more about intrafamily loans or need assistance crafting the terms of such a loan, contact InSight Law today.