In these uncertain times, intra-family loans have become a more competitive option than commercial loans and a low-cost estate planning tool to shift wealth between generations without incurring any gift or generation skipping transfer ("GST") taxes.
The IRS requires that any arrangement between family members greater than $10,000 to have a minimum interest. If such an arrangement does not state a minimum interest rate, the IRS will impute an interest rate. The loan must be documented with a written promissory note.
Under the Code, the minimum interest rate that must be charged is known as the applicable federal rate ("AFR"). For October 2020, the AFRs are as follows:
These minimum interest rates are at historic low levels. Even with commercial lending rates as low as they are today, these interest rates are significantly more attractive. Intra-family loans also have an advantage over third-party loans because the interest expenses can be paid directly to a family member during the loan term. Moreover, the costs associated with closing the loans are minimized. Finally, intra-family loans can be structured with flexible terms as compared to a commercial loan where the lender will want to include terms to their advantage.
Furthermore, intra-family loans can allow a significant shift of wealth between generations. If the younger generation can earn a greater return on the amount being borrowed than the AFR, then such younger generation can keep the return without having any gift or GST tax consequences. Intra-family loans can also be used to enable a child (or grandchild) to purchase a more expensive residence or vacation home than the child could otherwise afford. A mortgage can be used to secure the loan and ensure interest deductions. The loan can be structured as interest-only with a balloon payment at the end of the term to further enhance the attractiveness of the intra-family loan.
Related techniques may include forgiving part or all of the principal over time to take advantage of the lending family member's yearly gift tax exemption and lifetime exemptions.
While family dynamics should be considered before entering into an intra-family loan arrangement, the attractiveness of such an arrangement has never been greater given how low minimum interest rates are today.