Intrafamily Loans: The Good, the Bad and the Ugly

There are many tools in the bag of any good estate planner, one of which is the intrafamily loan. Most planners will recommend this option, depending on a family’s internal dynamics and the liquidity needs of the patriarch/matriarch. I’ve seen intrafamily loans work very well for many families to provide liquidity for the next generation, but I’ve also been involved in situations where loans lead to the breakdown of family relationships and can even put the lending generation at risk of a cash-flow crisis.

Intrafamily loans are most frequently made from Mom and Dad to one or all of their children or grandchildren. With the gift tax exemption currently at $11.58 million per individual, and $23.16 million per couple, the need to make intrafamily loans has decreased for most taxpayers, because parents can just gift money instead. However, there are still some good reasons to use this method to transfer money from one generation to another.

How intrafamily loans work

Intrafamily loans typically use the Applicable Federal Rate, the lowest interest rate that can be charged on a loan for it not to be considered a gift. The IRS has three rate tiers for the three different “terms” of loans: a short-term loan (0-3 years), a mid-term loan (3-9 years) and a long-term loan (9 years or more). The current AFR table can be found at https://apps.irs.gov/app/picklist/list/federalrates.html. If rates below the AFR are used, then the structure could be classified as a gift by the IRS.

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For example, if a loan was made to a child for three years, it would be classified as a short-term loan with the current AFR of 1.60% (as of March 2020). This rate can be used regardless of the creditworthiness of the borrower. In other words, if a child with terrible credit went to a bank to borrow the funds, it is likely they would either get turned down or have to pay an above-market rate to secure the loan. Intrafamily loans are not subject to underwriting and can be made anytime on whatever terms the parental lender deems appropriate, as long as the interest rate charged is the AFR or higher and actual payments are made.

Families can be creative in the method of the actual payments. For instance, a person can give each child or grandchild up to $15,000 each annually as a gift (or $30,000 as a couple). An annual gift could be made to the indebted child who could then use the gifted funds to make their annual note payment. Debt payments can also be forgiven, and the annual gift can be used for this as well; however, it is always my advice to make a cash gift and have the indebted child make payments. This is a much cleaner process and easier to document if an audit were to occur.

Uses for intrafamily loans

One use of intrafamily loans could be to purchase shares of the family business or partnership. This works well if the business or partnership produces income that is paid to the indebted child in order to repay the loan. Again, with the gift tax exemption at such a high amount, it might be easier to just gift the business to the child or children, but there may be good reason to sell the business on a note and keep the gift tax exemption intact. The primary benefit for selling the business and taking back a note is cash flow for the selling generation. If the business is simply gifted to the next generation, all income from the business is passed downstream as well; however, if a note is taken back by the selling generation, then annual note payments will provide parents with a nice income stream. It is important that an appraisal be done of any business interest or partnership that is to be sold.

An interfamily loan could also be used to fund a mortgage for children or grandchildren. If the parental lender doesn’t need ongoing market income based on their liquidity, a mortgage can be made to their children to buy a home and allow for lower payments than would be necessary through a conventional lender. The current long-term AFR (a loan of nine years or longer) is 2.15% (as of March 2020), while the current national average for a 30-year mortgage is around 4%, or much higher if the child has poor credit. The indebted child can also deduct their mortgage interest, subject to the itemization rules. The standard deduction may be a better route for some, but regardless, the interest payment would be much lower.

Situations to avoid

As positive as this arrangement can be, there are pitfalls of which to be wary. Intrafamily loans can create jealousy and relational problems among siblings. It has been my experience that when an intrafamily loan is done for one child but not others, it can put a strain on family relationships.

I’ve seen situations where one child becomes very dependent on family loans for situations including business investments, home loans, car loans or their own children’s education. It becomes an easy source of liquidity from parents who have the wealth to fund loans and not jeopardize their own financial future. But problems arise when there are other children who perhaps don’t need the loans, or who have lived more conservatively and see the spending by their sibling as wasteful. This can lead to resentment or even hostility toward the parents and sibling.

Another issue could occur if the asset sold on a note stops producing income and the child has no way to pay back the loan. This can create a serious cash flow issue for the parents if they are dependent on the loan payments as an income stream. It can trigger gift tax if the child can no longer make payments and the debt must be forgiven in an amount greater than $15,000 a year ($30,000 for couples).

Given this possible outcome, care should be taken to truly examine the intrafamily loan idea and make sure it’s a good choice. If loans are not being made equally to all children or grandchildren, parents should be especially on guard for potential relational issues or the possibility of enabling their children that can take place.