Over the past couple of years, the economy has been pulled in all directions. The effects have been seen through record-high home prices, higher interest rates, and inflation. While federal efforts are being made to calm the waters, these economic ripples are chipping away at the ability to enter—and stay in—the housing market.

Intra-Family Loan Basics

As a result of the economic backdrop, intra-family loans are on the rise. These transactions typically involve parents or grandparents who are well-positioned to help their children or grandchildren purchase their first home, but they can also be used to invest in income-generating rental properties or to launch a business.

More and more people are turning to family members for a private mortgage loan rather than seeking financing from a direct lender since the rates can be substantially less. The average commercial mortgage rate for a 30-year home loan is between 5 percent and 6 percent, while the long-term rate that the IRS specifies must be the minimum rate for an intra-family loan is hovering around 3 percent to 4 percent.

Each month the IRS updates the Applicable Federal Rates (AFR), a three-tiered set of minimum interest rates based on the repayment term of a loan between family members. These interest rates are correlated to bond yields and have no bearing on a borrower’s credit score. With a low interest rate environment, there are a number of advantages to intra-family lending.

Benefits and Considerations

The combination of lower interest rates and flexible terms in an intra-family loan make for an attractive alternative to a commercial loan for borrowers. In the same regard, lenders receive a higher interest rate than a traditional savings account.

While some wealthier family members could afford to give the money away, others prefer to formalize an intra-family mortgage loan to teach financial discipline, rather than dole out a financial freebie. Borrowers will then learn how to properly manage debt and build self-sufficiency.

If the borrower has less than ideal credit, an intra-family loan does not get reported to credit bureaus, so the loan will not be dependent on the borrower’s credit score and will not show up as debt for the borrower, which opens up more lines of credit for other purchases, such as a new vehicle or business investment. This could, however, be seen as a disadvantage for borrowers looking to build their credit.

If the loan is structured properly and registered as a mortgage, borrowers can claim a home mortgage interest deduction if they itemize deductions on their federal tax return. Current law allows taxpayers to deduct up to $750,000 for mortgage interest paid on the principal of their loan.

For lenders, intra-family loans can be an effective estate planning tool, ultimately keeping money in the family. If structured properly, it can serve as a tax-free wealth preservation and wealth transfer strategy.

Estate and Gift Planning Opportunities

A successful intra-family loan could be structured in a variety of different ways to benefit an estate. One of the biggest advantages is the arbitrage. Intra-family loans can be used to pass on assets, such as liquid funds or shares of a business, and strategically invested to bring in a higher rate of return than the interest rate on the loan. Any income the borrower produces on the loan amount exceeding the interest rate is not considered part of the lender’s estate, thus would grow without any estate or gift tax implications.

Similarly, the lender could loan money to a family trust to earn additional estate tax benefits and protections. For example, the trust could invest the money and repay the intra-family loan. Any assets that remain after the loan has been repaid are protected by the trust and can be allocated in accordance with the terms defined by the trust.

If for some reason, the borrower is unable to make a payment, the family lender can gift up to $16,000 in 2022 ($32,000 for married couples) without being subject to gift tax. Anything above $16,000 per individual will apply to the lifetime estate and gift tax exclusion amount of $12.06 million for 2022 and will need to be reported on IRS Form 709.

Should AFR rates go down, a borrower can refinance the same as they would with a traditional commercial loan. There is the risk that the IRS may treat the interest savings as a taxable gift at the time of refinancing, at which time the lender may choose to apply the savings to their annual gift tax exclusion amount.

To enjoy the benefits and estate planning opportunities surrounding intra-family loans, it is important to structure the loan properly and to be aware of the tax implications associated with the terms.

Tax Implications

Oftentimes, the IRS sees the transfer of money between family as a gift, unless the lender can show otherwise. While the IRS does not track intra-family loans, they may question their validity in the event of an audit. To keep it from being treated as a gift, it is important to properly document the transaction with the following terms:

• a formal promissory note,
• a fixed repayment schedule,
• a fixed interest rate no less than the AFR for the month in which the loan was administered, and
• proper records
  • Lender to file Form 1099-INT to report interest income
  • Lender to issue Form 1098 to borrower to show interest paid
  • A loan servicer can be used to receive payments and prepare the appropriate tax reporting forms

The beauty of an intra-family loan is that the terms and structure are flexible based on the best interest of the lender and borrower. And as mentioned above, the borrower may be an individual or a trust.

How to Get Started

With today’s low AFR interest rates, intra-family loans are an effective way to preserve and transfer wealth to help children and grandchildren, while also reducing future estate and gift tax burdens. Be sure to connect with R&A to discuss the tax complexities surrounding intra-family loans to avoid any unintended tax consequences.