With interest rates at historic lows, now might be an ideal time for parents or grandparents to lend money to family members.
Properly structured, intrafamily loans can have multiple benefits—from low interest rates for borrowers to estate planning perks for lenders.
But before signing on the dotted line, lenders must understand how these loans work—and how to avoid potential ambushes along the way.
There Are Rules in These Parts
It may come as a surprise that intrafamily loans require more than a hug or a handshake to seal the deal. Blame your forebears for this.
In the wild days of higher interest rates and far lower gift tax exemptions, some tricksters tried to pass off gifts to family as loans. Ever vigilant, the IRS got wind of this and laid down the law.
Intrafamily lenders must now charge, at a minimum, the Applicable Federal Rate (AFR)—the lowest rate that can be charged on a loan. Lenders can charge more, but rates remain fixed.
Fortunately, today’s rates are incredibly low. Short-term loans (0–3 years) are 0.14%. Mid-term loans (3–9 years) are 0.35%, and long-term loans (9+ years) come in at 1%. By comparison, 30-year fixed rate mortgages are hovering at 3%, nearly triple the long-term AFR.
The Advantages of Intrafamily Loans
Typically used to help family members reduce student loan debt, fund a business, pay off credit card debt, or buy a house (but not cover a down payment—that’s prohibited by bank regulations), intrafamily loans can be a boon for both borrower and lender.
Borrowers can benefit from lower interest rates compared with bank rates, no loan fees, and no required credit checks or underwriting.
Lenders get to keep money in the family, enjoy better returns than they would on cash languishing in a bank account, get the satisfaction of helping a loved one, and reduce potential estate taxes.
Heads Up for Trouble
Before easing into a loan agreement, both parties should hash out what happens when trouble spots—usually jealousy and payment complications—crop up.
If one child gets a loan, will the others, too? How will this affect family relationships? And what happens if the borrower defaults?
Generally speaking, the IRS pays more attention to intrafamily loans greater than the annual gift-tax exemption ($15,000 per individual / $30,000 per couple), but even those who lend smaller amounts will need a notarized loan agreement that states rate, term, repayment schedule, and default clauses to claim a deduction for nonpayment of the loan.
An additional piece of advice: Lenders might want to consider engaging an administrator, like National Family Mortgage, to simplify the process and ensure rules are followed.
Maintaining the Peace
Entering into an intrafamily loan agreement can, in the best of circumstances, present some challenges. At worst, it can be fodder for an outright family feud.
With the lifetime gift tax exemption currently at $11.58 million per individual ($23.16 million per couple), intrafamily loans won’t be for everyone, so we suggest you speak with your Vista team if you’re considering one.
