When interest rates are low, intrafamily loans can be a good way to assist a relative (typically a child) with purchasing a house or a family business, and in certain circumstances they can be used to gift money to the next generation.
An intrafamily loan allows family members to borrow money from each other at a special rate, but it must be structured properly so that the loan is not considered a gift. This means the loan must have a written promissory note, require repayment, and charge interest (if the loan is for more than $10,000). The IRS sets the Applicable Federal Rate (AFR) each month, and the interest on the intrafamily loan must equal the AFR. The rate is different, depending on the term of the loan, which can be a short-term loan (0-3 years), a mid-term loan (3-9 years), or a long-term loan (9 or more years). The AFR is typically lower than the interest rate a bank would charge, and the borrower’s credit doesn’t affect the loan, so someone with bad credit can still get a loan.
When structured properly, intrafamily loans can assist children with purchases and pass on assets. The following are some of the ways intrafamily loans can be used:
- Pay for a house. An intrafamily loan can be used to fund a mortgage for children or grandchildren. Because the interest rates are lower, the children will pay less overall than going through a traditional mortgage lender.
- Pass on a family business. Depending on how large the business is, giving away a business could exceed the prevailing gift tax exemption. Instead, parents can loan money to a child to purchase the family business. Parents who are financially able could use the annual gift limit ($15,000 in 2021) to give children money to repay the loan. Alternatively, if the family business produces income, the child can use the income to pay back the loan. Even if the business doesn’t exceed the gift tax exemption, this can be a good strategy for parents who want to pass on the business, but still need a steady income stream.
- Pass on assets. Intrafamily loans can be used as a method of passing on assets provided the borrower can invest the money in a way that brings in a higher rate of return than the interest rate on the loan. Given the low interest rate on intrafamily loans, this can be a successful strategy. If the loan is a large one, it may be wise to loan the money to a family trust. The trust invests the money and repays the loan. After the loan is repaid, the remaining assets are protected by the trust and can be distributed to beneficiaries as dictated by the trust terms.
The downside of an intrafamily loan is the same as with any loan: The loan must be repaid. If the child defaults on the loan, it could trigger a gift tax for the person making the loan. It is also important to have the correct paperwork and documentation. Intrafamily loans should only be set up in consultation with your attorney.