Thinking of making a big loan or gift to a family member?
One of the pleasures and privileges of having money is being able to give or lend it to others, especially those you care about. If your daughter is house-hunting for the first time or your grandson is applying to colleges, you may want to help them reach their goals, either in terms of a gift or an interest-free loan. But you may be unaware of some of the costs of doing so – and the clever ways to minimize them for both borrower and lender.
The surprising fact is that while a gift may be where the conversation starts, such help is often best structured as a loan.
Intra-family loans are a good option for the borrower, as the IRS-stipulated Applicable Federal Rate (AFR) is usually lower – sometimes considerably so – than what a bank or credit union can offer. As of January 2023, the annual AFR is 4.50% on a short-term loan (under three years), 3.85% on a medium-term loan (three to nine years) and 3.84% on a long-term loan (more than nine years). This compares very favorably with a typical commercial loan rate of around 7% for a fixed 30-year mortgage. The AFR is currently also below the Federal loan rates for students, which are 4.99% for undergraduates and 6.54% for graduate or professional students.
There are rules associated with making a loan to a family member, but they are relatively straightforward and easily addressed. It’s important to note that interest must be charged on the loan or the IRS considers it a gift, and that the interest charged is considered taxable income to the lender, based on the AFR at the time the loan is made.
Can I afford to do this?
For the borrower, one issue that can arise is how tying up the money involved might impact one’s other needs or retirement goals. If you stand to lose out, compared to what you might make in other investments – the “opportunity cost” – that should be part of the calculation.
Right now, intra-family loans are particularly attractive, because the current AFR is close to what you’d earn in shorter-term, traditional bonds. Today, if you make a bona fide loan instead of a gift, you’re still earning what you would elsewhere, and your family member borrows at a lower cost.
What if you want to be more generous than that? Why not just give them a lump sum and be done with it? This is where the math gets compelling. In 2023, anyone can gift any individual up to $17,000 – the amount of the annual gift tax exclusion – without triggering the need to file a gift tax return or reducing your federal estate and gift tax exclusion amounts. In terms of a loan, that means you can forgive up to that amount of the interest and/or principle each year without penalty.
You can still give, without estate tax penalties
Let’s say, instead of a loan to be paid back, you’d like to make an outright gift today that exceeds the annual gift tax exclusion amount. You and your spouse wish to give your daughter and her partner $300,000 towards a house. If you make an outright gift, you will need to file a gift tax return along with your federal and state income tax returns. And, since the gift exceeds the $17,000 annual gift tax amount, you will also have reduced the amount of your estate sheltered from estate taxes at your death.
Alternatively, in a loan scenario, right off the bat, between you and your spouse, you can still give your daughter and her partner each $34,000, which brings the loan amount down to $232,000. If you structure that remainder as a five-year (medium-term) loan, say, at just under 4%, and you continue to reduce the balance via loan forgiveness, penalty-free, by up to $68,000 each year, the loan will be reduced to nothing before the term is even done. Yes, you will have to calculate and pay income tax on the interest on the outstanding balance each year, but you have avoided any need for gift tax filings and preserved your maximum allowable estate tax exemption amounts while providing a valuable source of borrowing for your family.
And perhaps most importantly, in considering and possibly setting up such a loan, you have also answered the question many have: Can I afford to help my child?
Additional things to keep in mind in considering an intra-family loan
One of the pitfalls of this arrangement is that conversations about money within families can sometimes be tricky. It’s important to think carefully about how to explain this technique with a family member who has asked for a loan or is possibly expecting a gift because a sibling received financial help in the past. Perhaps you could share this article with them.
It’s also essential to document the loan agreement, and to stay on top of any balance that will be outstanding for a year or more, as your income tax returns will need to reflect the interest you have earned as the lender.
Proper family loan documentation can also help avoid serious legal disputes with other family members following an unexpected divorce or untimely death. However, don’t be intimidated: memorializing such an arrangement is not complicated, and we can help with this process. Generally, such documentation will indicate the dollar amount, the term of the loan, and the interest rate. Other conditions can include whether the loan is interest-only for a period of time, or whether a pre-payment penalty of the balance due applies.
We hope this explains how a properly structured intra-family loan allows you to maximize your generosity. At Bridgewater, we’re here to give families ideas and tools to support their financial well-being. Please reach out to us if you’d like to explore these ideas for your family.