Loans from The Bank of…. Mom and Dad?

Loan interest rates are rising. At the same time, interest earnings on savings accounts and CDs aren't exactly setting the world on fire! So what if a family member offers to finance your upcoming purchase instead of using the bank? The borrower avoids dealing with traditional financing and the interest paid stays in the family. Sounds like a win-win, right?! Not so fast.

Follow the Rules

Intra-family lending is simply a loan between family members. No bank, institutional underwriting, or credit scores need to be involved. But it does have to be more than a handshake deal.

If done correctly, intra-family loans are a great way to benefit the family and potentially pass assets to the next generation. However, if the loan isn't structured properly, the IRS could view the transaction as a gift and come knocking at your door.

Per the IRS, to qualify as a loan, the arrangement must include the following elements:

• Written promissory note
• Term of loan or repayment plan
• Loan interest rate
• Maturity date

Plus,

• Lender must receive some form of collateral
• Borrower must have the means to repay the loan
• Repayment records must be maintained

The IRS sets the minimum interest rate. However, even with all these requirements, the process can still be straightforward for a legitimate loan.

To ensure your promissory note has all the necessary details, you should contact an attorney who can draft the document. Of course, you could also choose to write up the note yourself, but the IRS could view the loan as a “gift in disguise” if it doesn’t contain all of the appropriate details.

Next, you'll need to determine the key terms of the loan. Since no underwriters or banks are involved, you can customize the term and payment structure to the situation. For example, if someone is launching a business, he/she may need time to increase cash flow. Therefore, payments could be lower in the first few years of the loan term and increased over time.

You do have to refer to the IRS when setting the interest rate. The Applicable Federal Rate (AFR) table, updated by the IRS monthly, breaks down the minimum interest rates into three buckets based on the loan term:

• Short-term loans are less than three years.
• Mid-term loans are between three and nine years.
• Long-term loans are more than nine years.

For example, the mid-term rate for loans established in August of 2022 is 3.15%. Compare that to a 6% used car loan rate and you can see why the intra-family loan might be worth exploring for the borrower.

Depending on how the lender is currently investing the funds earmarked for the loan, a guaranteed 3.15% might look good when comparing other conservative investments. You can set your interest rate higher than the AFR rates, but not any lower.

If the loan is greater than $10,000 or the principle is used to produce income, then the interest received by the lender should be reported on a Form 1099-INV and included on their tax return. If the borrower uses the loan as a mortgage, they can report the interest expense as a deduction on Schedule A of their tax return.

One Step Further- Intra-family Loans and Estate Planning

What if there isn't a financial need, but the parents want to begin to pass their assets onto their children? Intra-family loans are one strategy to explore. For example, the parents could loan their children a sum of funds to invest in a diversified portfolio. If the portfolio yield was 6% and the interest rate for the loan was 3%, the kids keep the difference. Eventually, they will have to pay the loan back, but they've been able to shift the earnings on those dollars from their parent’s balance sheet to their own.

What about forgiving the loan? The lender can choose to forgive the loan, but the amount forgiven is treated as a gift for gift and estate tax purposes. The borrower may also owe taxes on the unpaid interest.

The intangible element that hasn't been mentioned is the impact on family dynamics. Would lending money to a family member create tension or cause more significant issues? Conversely, what if the borrower isn't able to pay back the loan in full? Think through the worst-case scenarios before making any commitments.

Bottom Line

As stated before, intra-family loans can be a simple option to help borrowers save on interest expense and give lenders a yield on funds that may be otherwise sitting in cash. However, you should also review your financial security before offering to help others. Consult your financial planner to determine if an intra-family loan is a good option for you and your family.

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