Even though interest rates are at historic lows, many banks have maintained the stringent lending criteria that prevailed after the subprime crisis broke. Bank loans are still hard to come by, especially for younger borrowers. In response, many young families have turned to their parents or others among older generations for intra-family loans.
One of the great aspects of the intra-family loan is that it’s not just a good deal for the recipient; there can be estate planning benefits for the lender as well. Here are some of the advantages to such an arrangement, as well as other things to keep in mind.
The rates can be very low.
The lender can set very favorable terms for the loan, although it’s not unlimited; there has to be at least minimal interest charged. The IRS publishes the minimum rates, called the Applicable Federal Rates (AFR) each month.
For February 2014, the annual rate for a short term loan (of three years or less) is 0.30 percent. The rate for a mid-term loan (between three and nine years) is 1.56 percent, and the rate for a long-term loan (longer than nine years) is 3.56 percent.
Those minimums allow the older generation to provide very favorable terms to the recipient of the loan. But be careful not to go under those limits. If the interest rate charged is less than the applicable AFR, the lender could be forced to recognize taxable interest income equal to the difference between the rate charged and the AFR, though they’re not actually receiving income. That difference will also be considered as a gift from the lender to the borrower.
There are potential estate benefits.
These loans allow high-net-worth parents to move assets out of their estate. While the repayment plan obviously moves that money back into the estate, remember that the loan doesn’t have to be for a home or college or anything specific. A father can pass along a five-year loan to his daughter to make an investment.
All the investment then has to do to make the loan pay off is exceed the 1.56 percent minimum annual interest rate. The appreciation will accumulate in the daughter’s estate rather than the father’s.
They can transfer interest in a family limited partnership that controls family investments.