Lending to a child or grandchild can be a satisfying way to provide a financial resource, perhaps to help them finance a business, buy a home, or make another purchase. The borrower can benefit from flexible repayment terms as well as interest rates that are typically lower than ones on commercially-available loans, and the lender can offer help to a family member while promoting financial responsibility.
For example, I recently used an intrafamily loan to help my younger sister buy property. She owns two horses and was paying to board them at a farm near where she lived. She had calculated that buying a property big enough (and zoned appropriately) to allow her to board the horses herself would improve her cash flow and ultimately save her money, but she didn’t quite have the principal or credit history to get a commercial loan at an attractive interest rate. While there was additional paperwork to record the mortgage with the county and some minor ongoing tax related forms for me, the end result has been financially and emotionally advantageous for both of us.
A word of caution
An intrafamily loan is a nuanced strategy with many moving parts and a number of potential tax consequences, including implications for estate, gift, and income taxes. All of this should be considered in deciding whether an intrafamily loan is right for you and your family. In order for the transaction to be respected by the Internal Revenue Service (IRS) as a loan (rather than treated as a gift), the parties must comply with a number of requirements, which include: Ensuring that the borrower is credit worthy and has the means to repay the loan, establishing a formal creditor-debtor relationship, and charging interest at a minimum rate (known as the Applicable Federal Rate (“AFR”), amongst others. You can find the current AFR on the IRS website for short- (under three years), medium- (three to nine years) and long-term (more than nine years) loans.
If the family member is required to repay the loan principal but not the interest, the IRS will generally consider the imputed annual interest taxable income to the lender and a gift to the borrower which, depending on the amount (i.e. if it exceeds the annual gift tax exclusion), may be considered a taxable gift or counted against the lender’s lifetime gift and estate tax exemption.
The potential benefits of a family loan
While the paperwork on family loans is complex—and requires counsel from a tax attorney to ensure they satisfy IRS requirements—they otherwise offer enormous flexibility. The borrower doesn't necessarily need to have a pristine credit history or collateral; the loans can be used for nearly any purpose; and they can be repaid in a variety of ways—including regular monthly payments to interest-only payments with a balloon payment due at the end of the term.
For example, an adult child may want to start a business that requires seed capital to get up and running. If the child borrows from a commercial lender (if that option is viable), the repayment of the loan will begin almost immediately, at a time when cash flow may be strained or when the borrower may be seeking to reinvest in the business for future growth. If the child borrows from a family member, the loan could be set up as an interest-only loan with a balloon payment due at some point in the future, presumably when the business is producing adequate cash flow.
Other potential uses of intrafamily loans include providing funds so that the borrower can purchase a home or create an investment portfolio. Additionally, while parents may be able to give money outright, or in trust, to their children, loaning money to them via an intrafamily loan may provide children a sense of ownership over how they use the funds and of responsibility to make timely payments. It may also allow for deeper conversations relating to money and wealth, providing an opportunity for family members to discuss their goals and wishes.
The wealth transfer angle
If structured correctly, an intrafamily loan can be an effective way to transfer wealth between generations without reducing the lender’s lifetime estate tax exemption. For example, if a borrower used the loaned funds to establish an investment portfolio and the investment portfolio grows at a rate greater than the interest rate charged on the loan, the lender would have transferred a portion of the growth on the loaned funds to the borrower without using any of the lender's estate tax exemption.
However, higher interest rates can reduce the attractiveness of an intrafamily loan as an estate planning tool. That’s because the lower the interest rate on the loan, the higher the likelihood that the growth on the invested loan proceeds will outpace the interest payments. In addition, there may be tax consequences of the transaction, including income tax consequences for the relevant parties (for example, an intrafamily loan may eliminate the possibility of a step-up in the cost basis of an investment portfolio and thereby result in increased capital gain taxes that the borrower would not otherwise have owed).
Keep in mind that an intrafamily loan typically only transfers potential growth on the loaned assets; it does not necessarily reduce the lender's gross estate because the loaned funds plus interest are intended to be repaid and would therefore be included in the lender’s estate.
In addition to lending funds to an individual family member, it is also possible to loan funds to a trust for the benefit of family members. Many of the same considerations would generally apply, with a few differences, including that the loan would be made to a trust rather than to an individual and the trust must be funded with collateral, or seed money, to be considered a bona fide borrower. This strategy could be layered with other trust strategies that could potentially provide additional advantages. The rules regarding trusts are complicated, and you should consult with your legal and tax professionals when considering this and other structures.
More considerations
Every financial decision has the power to create closeness or distance in family relationships. When trying to determine if an intrafamily loan is appropriate in your situation, some questions to consider may include:
- Will lending to one child cause other children to feel this arrangement is unfair to them?
- Should different types of loans be considered for different children, based on their personal situations?
- If the child is unable to, or chooses not to, pay back the loan, will a loan default cause family friction?
Finally, keep in mind that the structure of a family loan is extremely important. Careful consideration needs to be given to the various consequences of the arrangement, including the income, estate, and/or gift tax implications. The tax rules regarding intrafamily loans are complex, and such an arrangement may result in adverse and unintended tax consequences if not implemented correctly. Families interested in this type of transaction should consult with their legal counsel and tax advisor to discuss whether this type of arrangement is right for them and to structure the transaction in a manner designed to achieve the intended tax treatment.
David is responsible for Fidelity's estate and wealth planning activities, including creation of new thought leadership in these areas. He heads a team of professionals that develops and delivers the depth and breadth of Fidelity's wealth planning offering.
Prior to joining Fidelity, David was managing director and head of Insured Solutions for UBS Wealth Management Americas. He served as chief operating officer of UBS Wealth Planning. David first joined UBS as a senior member of UBS Private Wealth Management, and was involved in the creation of that business for the firm. During his tenure with UBS, he also served as the chairman and president of UBS Life Insurance Company USA, Inc.; the chairman and president of UBS Financial Services Insurance Agency, Inc.; and a board member of UBS Trust Company, N.A.
Prior to joining UBS, David was a director in Merrill Lynch's Private Banking & Investment Group. He joined the firm's International Private Banking business in London and was a key member of the firm's Corporate Strategy unit.