With affluent Baby Boomers sitting on loads of cash, intrafamily loans can be a win-win, so long as you pay attention to the tax rules and the paperwork.
By Kelly Phillips Erb, Forbes Staff
Ever since the Federal Reserve started fighting inflation by driving up interest rates, banks’ prime rate, on which so much adjustable and short-term loan pricing hinges, has climbed from 3.5% in March 2022 to 8.5% now. That has pushed unsecured personal loans above 12% and average credit card interest above 21%. Thirty-year fixed mortgage rates have been flirting with 8%, up from under 3% in 2021. Those unpleasant numbers, combined with favorable tax rules governing intrafamily loans, make borrowing from the Bank of Grandma a savvy option for many well-off families, particularly if the older generation is sitting on gobs of cash.
In addition to a healthy family dynamic, the keys to making these loans work are planning, paperwork and, most importantly, insisting that Grandma charge the current “applicable federal rate” (AFR)—the minimum fixed interest a private lender must levy on a new loan to avoid unwanted tax complications. In December, the AFR was 5.26% a year for loans of three years or less; 4.82% for midterm loans of up to nine years; and 5.03% for longer-term loans such as 15- and 30-year mortgages. They represent “a really excellent alternative to prime rates,” says Laura Mandel, chief fiduciary officer at the Northern Trust Company in Chicago.
What happens if you don’t charge the AFR minimum? The IRS could argue that you’re making a disguised gift to the borrower. Indeed, you might want to use a loan to transfer money over time through loan forgiveness, but you don’t want to do it inadvertently.
In August, Justin Miller, national director of wealth planning at Evercore, the big New York City investment banking firm, helped a retired couple extend a $2 million interest-only mortgage to their 30-something son and daughter-in-law for the purchase of a home in San Francisco—conveniently located for seeing their two grandchildren. They hired a lawyer to draft the proper loan documents, with a mortgage recorded against the property. The young couple can deduct the interest paid on the first $750,000 of borrowing, the same as if they had used a traditional bank. All the interest paid is taxable to the retirees and yields a return comparable to what they might get in a money market fund. “The children now live in a beautiful $2 million home, and any appreciation will happen outside of the parents’ estate,” Miller says.
Meanwhile, the retirees, cash-rich after the recent sale of a business and receipt of an inheritance, are also using their annual gift exclusion—the amount anyone can give anyone else each year with no gift tax consequences—to further help the young family. (For 2024, the exclusion is $18,000, or $36,000 if you split gifts with your spouse.)
Why not simply make a big gift now so the couple could buy the house with a smaller commercial mortgage? The retirees, still in their 60s and committed to charitable giving, aren’t ready to do any large wealth transfers yet. And, Miller says, there’s this: Heaven forbid, should the young couple’s marriage go south, any gifted money invested in their jointly owned house would be community property in California, to be split equally between them. With a loan, if divorce or other circumstances means the house must be sold, the retirees get their $2 million back first from the proceeds of the sale.
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Taking collateral and registering a security interest is essential for a mortgage, but it’s also helpful for smaller loans, says David Oh, head of tax and estate planning at Arta Finance, a Mountain View, California–based fintech serving accredited investors with a minimum liquid net worth of $1 million. Even small loans should be documented with a signed promissory note that at minimum spells out the interest rate, repayment terms and what will happen in the event of a default. That should keep both the IRS and misunderstandings at bay. (You can complete a promissory note for a small loan using a form on the web, but get a lawyer’s help for amounts you’re not prepared to lose.) Some families even use professional loan servicing firms to bypass awkward in-person financial exchanges.
As for turning loans into gifts, the annual gift exclusion can be used to forgive both interest and principal over time. Indrika Arnold, a senior wealth advisor at the Colony Group in Concord, New Hampshire, encourages some clients to forgive even bigger loans as a way to make use of their lifetime exemption from gift and estate taxes—$13.6 million per person or $27.2 million per married couple in 2024—before it drops in a couple years. Unless Congress decides otherwise, it will fall by about half in 2026, but gifts that have already been made will be safe.
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Loans can also be forgiven after death, typically by a provision in the will, but be aware that a loan that remains outstanding at the death of the lender is considered an asset adding to the value of the estate, cautions Jim Bertles, an estate lawyer and managing director of AlTi Tiedemann Global in Palm Beach, Florida. If the plan is to forgive the loan in its entirety, the len-der should consider including equalization terms in the will—that is, if one child’s note is for-given, payments are made to any other children to ensure that the estate is distributed equally (assuming that’s the goal). That strategy could backfire if you’re not careful, given that preplanning for forgiveness could signal to the IRS that you never intended it to be a legitimate loan. The way around this? Simply leave your kids enough money to pay off the loan.
There are other, more advanced ways to make intrafamily loans work for a wealth transfer. One of the most popular is combining a loan with what’s known as an intentionally defective grantor trust, or IDGT, Bertles says. During their lifetime, the grantor places appreciating assets in an IDGT for heirs, freezing the value of those assets for estate and gift tax purposes. (Crafting it as intentionally defective means any income in the trust will be taxed annually to the grantor, not the trust, turning the income tax paid into an additional gift tax–free transfer to heirs.)
Here’s where the loans come in. Rather than fund the IDGT with a gift, the grantor can make a loan to the trust, with the money then used to make investments that will (ideally) appreciate and throw off income, which is used to repay the note. The key, Bertles says, is that the return on the investment must be more than the interest rate. That way, the spread will pass transfer tax–free to the trust. In the end, the grantor’s taxable estate is lower than it would have been without the IDGT and the loan, making it a win-win for the family.
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