“A banker is a fellow who lends you his umbrella when the sun is shining and wants it back the minute it begins to rain.” – Mark Twain
Interest rates are low and credit remains tight. This can create a problem for adult children looking to buy a home, start a business, or seek an advanced degree. For parents, lower interest rates have translated into less interest income.
What if the solution were as easy as removing the intermediary?
Family + Money seldom equals easy, but the current market dynamics make intra-family loans worthy of consideration.
When considering an intra-family loan, your first thoughts are probably qualitative in nature.
- Is this in-line with my financial goals and objectives?
- Is this loan fair to other children and grandchildren?
Beyond these hurdles there are important legal and financial considerations. For the lender it’s important to think objectively. Questions to ask include:
- Will a down payment be required to incentivize repayment?
- Does the timing and amount of the loan fit within my broader portfolio?
- What happens in the event of default?
- How does default impact my financial independence and am I willing to accept this risk?
- Should I modify estate documents to account for the loan?
If after you have carefully considered these factors, you are ready to move forward, then what?
First and foremost the loan should be treated as an “arm’s length transaction.” This includes preparing a written agreement, including an amortization schedule and pre-determined late payment penalties, signed by both parties. This agreement could be something you draft yourself, online with assistance, or hire an attorney to draft. Designing the loan in this manner will enhance the probability of repayment and decrease the odds of a family dispute.
The structure of the loan will depend on a number of factors. From a purely tax perspective, cumulative loans between a single lender and borrower of less than $10,000 do not require interest be charged.
Loans above $10,000 require a minimum rate of interest be charged for gift and income tax purposes. This rate, known as the applicable federal rate, or AFR, changes monthly, and is at historically low levels. Using a rate less than AFR, or charging no interest at all, requires the calculation of “imputed interest” which represents a gift from the lender (and gets very complicated from a tax standpoint).
Rates for April 2011 are:
- 0.55% for short-term loans of up to 3 years
- 2.46% for mid-term loans of more than 3 years but not more than 9 years
- 4.17% for long-term loans of over 9 years
Remember, the AFR is the minimum rate of interest that must be charged. You can always choose a higher rate.
Win-Win Example:
Let’s say Mom & Dad have a $50,000 5 year CD maturing. The rate on a new 5 year CD would be about 2%. Their daughter would like to remodel her home, and the rate being quoted by the bank for a new loan would be 4.5%. There is an opportunity here.
Mom and Dad could loan their daughter $50,000 at 3.0%, earning 50% more than a comparable CD, while their daughter saves 1.5% per year in interest expense.
If at some point in the future, Mom and Dad decide to forgive a portion of the debt, they can do that – but it would be a gift at that time, and proper attention to the gift tax rules and any tax filings would need to be taken into consideration.
Reporting interest from an intra-family loan is no different than working with a bank. The lender reports the interest income on their tax return. The borrower might be able to deduct the interest expense (the rules are a bit complex – consult with a tax advisor if the borrower hopes to deduct the interest).
The decision to enter into an intra-family loan requires many qualitative and quantitative factors. We welcome the opportunity to discuss your unique circumstances in greater detail. When in doubt, focus on making an objective decision, much like a banker would do!