Intra-family loans are an excellent way for families to share the wealth without disrupting their estate and gift tax exemptions. These types of loans, however, aren’t always easy to structure.
While individuals can put intra-family loans together themselves, the services of an experienced estate planning attorney and possibly a tax advisor should be considered to avoid possible complications or having the loan contested by the IRS.
What Are Intra-Family Loans?
Intra-family loans are formal agreements that are often used by wealthy families who want to help out other members of their family without using up their lifetime gift tax exemption. They are often used to buy a home or start a business. Since these types of loans are often subject to much lower interest rates than the prevailing market interest rate in commercial transactions, they are an attractive way to transfer money between generations. These loans should not be mistaken as wealth giveaway, however.
To avoid having the IRS contest an intra-family loan, individuals need to have a promissory note, a fixed schedule for repayment, an interest rate set that is equal to or above the applicable federal rate (AFR) that is currently in effect, the debt must be secured, and the lender must demand repayment. Records should also be kept to show that it is an actual loan. Loan forgiveness should also be avoided. If an intra-family loan is made and a few months later the lender decides that it does not need to be paid back, it then becomes a gift.
Possible Tax Implications
If the IRS considers an intra-family loan a gift, there can be undesirable tax consequences. The borrower, for example will either be required to use a portion of his or her lifetime gift tax exemption, or he or she may have to pay out gift taxes that could be as much as 40 percent. If the loan is forgiven, the borrower would be required to pay income taxes on the total amount forgiven.
While borrowers must demonstrate repayment, loans can be structured with interest-only payments that include larger balloon payments at the end. Lenders must then claim the interest charged as income and pay applicable taxes.
Although Intra-family loans can be very complex, they are often an excellent estate planning tool to enable wealthy family members to help others purchase a home or build a new business.