She’s done all the right things: She’s worked hard in school, earned an advanced degree and has laid the groundwork toward finding a job in a well-paying career. Impressive as this recent graduate’s successes are, banks aren’t in the habit of giving mortgages to the unemployed.
So why not remove the bank from the equation?
A popular workaround when someone without enough cash on hand is looking to make a major purchase is an intrafamily loan, where a parent or other family member lends money in a formally structured agreement. These types of loans come without the hurdles of those offered by a bank, and there can be other tangible benefits as well, including lower interest rates, versatile payment options and estate planning opportunities related to how the loan is structured.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
These benefits come with the common drawbacks inherent to lending money — no matter how closely related the parties are, there is always an element of risk — but a well-rounded understanding of intrafamily lending can potentially provide significant upside for both parties. And oftentimes, intrafamily loans can make sense even when the recipient has a job that pays well or another source of income.
Just helping out
The types of loans implemented in intrafamily lending don’t necessarily have to be in the family. In fact, anyone can lend to anyone, any amount, for any number of reasons, from an aunt helping a niece secure a new vehicle, to a friend helping another with capital to help start a business, to a grandparent establishing a trust to provide for a grandchild while moving assets outside their taxable estate.
Smaller loans don’t necessarily have to be structured the way a regular bank loan is. If the amount is small enough — say, $10,000 from a parent to help pay off a child’s vehicle — the lender can simply transfer the funds and allow them to be qualified as a gift. Because the amount is below the $15,000 gift tax exclusion threshold for individuals ($30,000 for married couples) there would be no associated gift tax due, assuming that total gifts for the year do not exceed the annual exclusion.
Carrying the full load
A common, and more complicated, form of intrafamily lending is a mortgage. Let’s say our overachieving-yet-cash-strapped grad wants to buy a $300,000 home. Unless she has already landed a good job and squirreled away enough savings for the down payment, the bank isn’t likely to be interested in lending to her. But if her parents have the means, they can loan the child a portion of the mortgage, or the entire mortgage amount. With the guidance of their financial adviser and an attorney, the parents can construct a home loan with advantageous terms for their family — one with no money down, no pre-approval, no credit check and no background check. The child is just getting a loan from the “Bank of Mom and Pop.”
Perhaps the best part of this arrangement is that the interest payments stay in the family and will likely come back to the borrower one day as part of their inheritance. But in the short-term, the interest rate they will be paying will not only be lower than those on mortgages from commercial banks — it will be the lowest rate allowed by the IRS. As of July 2019, the compound annual applicable federal rate (AFR) is 2.13% for a short-term period (three years or less), 2.08% for mid-term loans (more than three years on up to nine years), or 2.50% for a longer term (more than nine years).
Crafting loans
When drawing up a loan with your attorney, there are several key considerations and procedural steps to take. If the loan is a mortgage, the lender needs to create a promissory note and file the mortgage within their county to make it official. In this, intrafamily mortgages are different than other types of loans.
Two of the most important factors when designing the loan is making sure it stays distinct from a gift. Lenders can do this by establishing it with an interest rate based on the current AFR and setting up an appropriate payment structure. Failure to do so may bring scrutiny from the IRS, leading to a potential penalty or a gift tax being imposed. And, just to be clear, the gift tax would be owed by the person who gave the gift, not the one who received it.
Tips on structuring the loan: I typically recommend to my clients that they make their mortgages interest-only, with a balloon payment scheduled for the end of the loan’s term. If at the end of the loan the lender wishes to refinance, they of course have the option to do so. Likewise, if the recipient is unable to keep the payment schedule, the lender may decide to forgive the interest at the end of each year. Again, the lender could use their annual gift tax exclusion to forgive the required payment without money being exchanged and the IRS would consider the payment “made.”
It’s worth noting that for a loan recipient to pay down the principal, they are really just shifting cash back to the lender’s estate, and they probably don’t need the money if they’ve just lent the child hundreds of thousands of dollars. Another way to look at is it that the recipient of the loan is also likely going to inherit a portion of the lender’s estate. So, they might they ask themselves, who will benefit more from the incremental cash they would apply to principal, the younger version of themselves just starting out, or the future version, who is more established in their career and is a beneficiary of the lender’s estate?
Intrafamily loans can provide families a simplified way to make complex purchases, with more flexibility and favorable terms compared with what they would get from a traditional bank. The key to making such a solution work is to align the structure of the loan with the financial means and goals of both parties, and to manage the note and all related payments and documentation in accordance with regulatory requirements.
-
Increasingly, Red States Embrace Marijuana: The Kiplinger LetterThe Kiplinger Letter Ohio becomes the 24th state to legalize marijuana for recreational use via a voter referendum.
-
Charlie Munger of Berkshire Hathaway Has Died
Charlie Munger, vice chair of Berkshire Hathaway, died Tuesday, the company confirmed.
-
The Best and Worst Ways for Retirees to Give on Giving Tuesday
Cash donations are certainly the most convenient, but you could be overlooking significant tax advantages by taking the easy way.
-
From Breadwinner to Retiree: How to Manage the Transition
Many people arrive at retirement with mixed emotions, including anxiety. Making the transition involves a profound shift in your mindset.
-
It’s Giving Tuesday: Charity Strategies the Wealthy Can Apply
When markets are down and interest rates are high, philanthropy can take a hit. Here are some ways that affluent consumers can make the most of their charitable giving.
-
Looking for a Job? Here’s How Not to Get Hired
A pair of HR consultants offer some advice to help people heading out on interviews to land that job.
-
Three Ways to Protect Your Retirement From Sequence of Returns Risk
Retiring in a down market doesn’t have to ravage your retirement, but safeguarding your savings requires planning well in advance.
-
Single-Premium Insurance: A Different Way to Pay for Coverage
Single-premium programs enable you to pay future annual premiums on an existing or new policy by purchasing a single-premium immediate annuity (SPIA).
-
Six Charitable Giving Strategies: Feel Good and Cut Your Taxes
These strategies can help you spread the love even more to charities you trust while also taking advantage of different kinds of tax benefits.
-
Four Reasons to Rent When You Downsize for Retirement
Renting is great when you want to test-drive a location, or you want more predictable costs. It might be easier for family relationships in the long run, too.
