Is an Intrafamily Loan Right for Your Family?
Samantha R. Webster, CFP®
Family is a gift that keeps on giving, and one of the greatest gifts you could provide your family members is the gift of helping them achieve their goals and dreams. One of the biggest obstacles many people face when trying to further their goals is finding the money to do so. Traditionally, it is expected that if you do not have the money for a large purchase such as a house or business, you must apply for a loan with a bank or financial institution. You are then subject to their terms, interest rates, as well as time constraints. This can be a difficult and unnecessary option for some families who may be able to provide the loan directly with an intrafamily loan.
Intrafamily loans are typically made from parent to child or grandparent to grandchild, but they are often utilized as a means of keeping wealth in the family and avoiding traditional lenders who may charge higher interest rates. If your child or grandchild does not meet the credit requirements for a traditional loan, there is a good chance they will either be turned away or be left with a high-interest rate determined by the lender. With an intrafamily loan, you could help fund their future and prevent unnecessary expenses.
For some families, this can also be an estate planning strategy of where the dollars are removed from the lender’s estate by placing them in an irrevocable trust. The trust then makes the loan and then the loan payments are returned to the trust, keeping the transfer of wealth seamlessly within the family.
With an intrafamily loan, interest still has to be applied to avoid later tax complications for the family lender, but you are able to charge the minimum market rate that is based on the IRS’s Applicable Federal Rates (AFRs). These rates are updated monthly and are determined by a variety of economic factors, including the prior thirty-day average market yields of corresponding US treasury obligations, such as T-bills. When deciding the appropriate IRS Applicable Federal Rate for a family loan, the lender should determine:
- The length of the loan repayment;
- The IRS Applicable Federal Rate for that repayment term during the month in which the loan is made.
To determine the current rates, you can check the IRS’s AFRs for the month of the loan HERE. There are three AFR tiers based on the repayment term of a family loan:
(1) Short-term rates, for loans with a repayment term up to three years.
(2) Mid-term rates, for loans with a repayment term between three and nine years.
(3) Long-term rates, for loans with a repayment term greater than nine years.
It is important to note that since an intrafamily loan is made with the full intent of repayment, it is important that the terms of the loan are recorded in a promissory note with tracking of the payments of interest and principal. If not properly recorded and tracked, the IRS may classify the loan as a gift and tax accordingly.
Intrafamily loans could be a helpful option for many families looking to ease the financial burden that may come from a traditional loan and could help family members transfer wealth. It requires important attention to detail and careful record-keeping, so if you are considering such a loan, it may be beneficial to discuss it with your advisor.
Investment advisory services offered through Ciccarelli Advisory Services, Inc., a registered investment adviser independent of FSC Securities Corporation. Securities and additional investment advisory services offered through FSC Securities Corporation, member FINRA/SIPC and a registered investment adviser. 9601 Tamiami Trail North, Naples, FL. 239-262-6577.