Debunking the myths of lending money to family

Intra-family loans are one of the easiest and most effective estate-planning tools out there

One of the best-kept estate planning secrets is the “intra-family loan,” an arrangement in which one family member lends money to another at an interest rate that is much lower than the prevailing market interest rates.

The intra-family loan is one of the easiest and most effective estate-planning tools out there, especially in this low interest rate environment. It is simple to implement and the annual or monthly management is no more complicated than your average mortgage payment.

The estate-planning benefits are very straightforward. If mom lends her son Charlie $1 million for a period of three years, Charlie is free to invest those funds in any way that he chooses, and must return those funds to his mother at the end of the three years, with interest.

If Charlie invests those funds and earns more money than he has to repay to his mother in interest, Charlie can walk away with a nice profit.

For example, if mom lent Charlie that $1 million for a single year on Jan. 1, 2013, and Charlie invested the funds in the S&P 500 Index for all of 2013, Charlie would have earned 29.6 percent on his investment, or $296,000. Based on the minimum interest rate of 0.21 percent that mom had to charge for a loan in January 2013, Charlie would have repaid his mother $1,002,100, leaving him with a profit of almost $294,000.

From an estate-planning perspective, this works beautifully because all of that profit (i.e., the arbitrage above the applicable interest rate) passes to Charlie without any gift or estate tax, as long as the stated interest rate on the loan is greater than or equal to the Applicable Federal Rate (AFR).

The AFR is a set of interest rates that is published monthly based on outstanding marketable obligations of the United States. There are short-term, mid-term and long-term rates that are determined based on the preceding two months’ average market yield on marketable Treasury bonds with corresponding maturity.

The short-term rate applies to loans that are less than three years in duration. The mid-term rate applies to loans that are more than three years but less than nine years in duration. The long-term rate applies to loans that are more than nine years in duration.

For example, in February 2014, the short-term annual AFR was 0.3 percent; the mid-term annual rate was 1.97 percent; and the long-term annual rate was 3/56 percent.

Best practices

Of course, the key to any solid estate-planning technique is to make sure that you establish and follow through with the relevant formalities of the arrangement.

Always make sure that your promissory note reflects the appropriate AFR for the date the loan was made. Use “term loans” – loans with a fixed termination date – instead of “demand loans,” which are loans that must be repaid at the request of the holder.

Like every arm’s-length loan transaction, it is best if the borrower actually has the ability to repay the loan. The debt should be collateralized or secured and the parties should maintain records and written evidence of demands for payments by the holder and actual payments made by the borrower.

Finally, with respect to loans used to finance the purchase of a home, in order for the interest payments to be deductible by the borrower, the debt must be secured by the qualified residence, the residence must be able to be foreclosed upon in the event of default, and the security interest must be recorded or otherwise perfected under state law.

Failure to follow some of these basic parameters may result in the imposition of gift or estate taxes or, in the case of the loan to purchase real estate, the loss of the mortgage interest deduction.

Intra-family loans are simple, and the documentation is straightforward. The tax treatment is relatively clear. The lender will have income to the extent of any interest payments that are due, but the payments stay within the family, which helps preserve the overall family wealth.

The current low interest-rate environment means that clients can lock in these benefits for the long term. It is an excellent strategy for those clients who don’t want to permanently lose control over their principal, and it allows the transfer of wealth to happen more gradually (instead of all at once with a singular gift).

Finally, for those clients who have already made full use of their lifetime gift exemption, an intra-family loan is a great way to transfer additional assets to their family members.

Amiel Z. Weinstock, an estate planning and tax attorney, is general counsel of Thomas Brady & Associates.