A low-yield and interest rate environment can be a difficult time for investors searching for total return from their investments. At the same time, any savvy investor should be looking for opportunities from a total wealth-planning perspective. As a result, with very low-interest rates, there are many family wealth transfers and planning opportunities that may be appealing. Intra-family loans in particular are appealing now while rates are at the lowest they have ever been.
Intra-Family loans are a unique way for families to loan, and sometimes transfer, wealth at competitively-low interest rates. In fact, June 2020 is shaping up to be the best month every for intra-family loans to younger family members. In June, a 30-year interest-only loan at 1.01% can pass wealth to children or grandchildren while avoiding gift, estate, and generation-skipping transfer taxes - while also possibly providing protection of assets from divorce or creditors. As such, those that have the means and are looking to share wealth with loved ones - while minimizing adverse tax implications - should consider whether an intra-family loan fits into their overall strategic wealth plan. However, intra-family loans come with serious considerations and if not carefully structured can result in unintended consequences.
Section 1274 of the Internal Revenue Code dictates that a loan among family can be established so long as a “market” rate of interest is used. For taxpayer purposes, this “market” rate of interest is the so called “Applicable Federal Rate” (AFR). The U.S. Treasury updates the short, mid, and long term AFR on a monthly basis and publishes it for taxpayers to use as a point of reference when establishing minimum “market” rate loans. Short-term loans are those which are three years or less, mid-term are those between three and nine years, and long-term are those which are nine-years or longer in duration. The appealing part of the monthly AFR to taxpayers, and those looking to transfer wealth explicitly or implicitly to family members, is that these rates are considerably lower than that which a borrower could obtain commercially in the open market. The AFRs for June 2020 can be found here and we can see that the short-term AFR is only 0.18%, the mid-term only 0.43%, and the long-term rate only 1.01%.
These low rates make for appealing wealth planning opportunities. It’s not hard to imagine finding an investment opportunity that can outperform the stated AFRs. As such, any appreciation that an investment can realize above and beyond the AFR on the loan is wealth that has effectively been passed from one family to another free of any gift or estate taxes. Some common uses of an intra-family loans include, assisting family members to buy a home, buy a car, start a business, provide an informal line of credit, and on and on. With the lower interest rates available through the “family bank”, there are plenty of interest rate arbitrage and saving opportunities.
Beyond simply using a low rate of interest, a lender can structure the note in a variety of favorable ways. For example, using a balloon note with interest-only payments for the duration of the loan and principal payments due at expiration, funds can be shared with the maximum opportunity for growth and enjoyment. With long-term rates at basically only 1%, a 30-year family mortgage could save and keep significant wealth in the family rather than have it go to interest payments a commercial loan may require. If the note is structured as an interest-only note, only interest payments are made, based on the balance of the loan. Using a simple example, a 30-year, interest-only, $500,000 family mortgage may require roughly $5,000 of annual interest payments as long as the principal balance remains outstanding. At the end of the 30-year term, the $500,000 could be repaid (or forgiven potentially), having allowed the family borrower to have accumulated and invested other funds during the duration of the note, likely in excess of the $5,000 they owed each year on the intra-family loan. Keep in mind though that the interest received by the lender is taxable income to them. The lender could even still apply their $15,000 annual gift tax exclusion towards the interest portion - effectively waiving any interest payments due each year, and saving over $150,000 of wealth for the borrower (over 30 years).
While the above, and other strategies involving wealth transfer using intra-family loans are quite appealing, it is important that the loans are created with the initial intention of full repayment, and that accurate records are kept. It is critical to draft and memorialize a true promissory note, along with an amortization schedule. Track payments of interest and principal associated with the note and its terms. If the intra-family loan is not properly documented and adhered to, the IRS could reclassify the loan as a gift, and tax it accordingly. However, with proper planning and strategic forgiveness being built into the loan along the way, it is possible to pass wealth while minimizing or entirely avoiding wealth transfer taxes.
An intra-family loan can help families and beneficiaries meet a variety of borrowing, wealth transfer, and wealth accumulation goals in more flexible ways than using commercial borrowing. Given the incredibly low interest rate environment we are currently faced with, now is as opportune of a time as ever to consider this strategy. Work with a team of experts, including wealth planning, tax, and estate professionals to achieve the optimal outcome. If you have questions on intra-family loans or other estate planning techniques, please contact us.
Disclosure: Hudson Oak Wealth Advisory LLC (“Hudson Oak” or “Hudson Oak Wealth”) is a registered investment adviser in the State of New Jersey & New York. For information pertaining to Hudson Oak’s registration status, its fees and services and/or a copy of our Form ADV disclosure statement, please contact Hudson Oak. A full description of the firm’s business operations and service offerings is contained in Part 2A of Form ADV. Please read this Part 2A carefully before you invest. This article contains content that is not suitable for everyone and is limited to the dissemination of general information pertaining to Hudson Oak’s Wealth Advisory & Management, Financial Planning and Investment services. Past performance is no guarantee of future results, and there is no guarantee that the views and opinions expressed in this presentation will come to pass. Investments involve risks and may lose value. Figures displayed within this communication are for illustrative purposes only. Nothing contained herein should be interpreted as legal, tax or accounting advice nor should it be construed as personalized Wealth Advisory & Management, Financial Planning, Tax, Investing, or other advice. For legal, tax and accounting-related matters, we recommend that you seek the advice of a qualified attorney or accountant. This article is not a substitute for personalized planning from Hudson Oak. The content is current only as of the date on which this article was written. The statements and opinions expressed are subject to change without notice based on changes in the law and other conditions.