With more stringent mortgage lending regulations these days, many adult children may look to their parents as lenders when they seek to borrow money for a house or other large purchase.
For parents, an intra-family loan can offer an opportunity to transfer assets, earn interest, and avoid triggering a gift tax.
If a family loan is structured properly, there are no gift tax or estate tax implications and families can still make use of the $14,000 annual gift tax exclusion and the lifetime combined exclusion of $5.43 million for gifts and estates.
Most investors may not be aware of the tax laws regarding these loans. A 2012 survey found 64% of those polled age 45 and older were “not at all familiar” with regulations requiring lenders to report earned interest income from certain loans.
To avoid IRS scrutiny, there must be a formal agreement including a promissory note with the terms of the loan and the repayment schedule.
The lender must charge an interest rate based on prevailing IRS guidelines. Each month the IRS publishes the Applicable Federal Rates (AFRs) for loans of different maturities including short term (0–3 years), mid term (3–9 years), and long term (9 years or more). The lender can charge a higher interest rate, but he or she cannot charge a rate that is lower than the prevailing AFR or the IRS will consider the loan to be a gift.
With the current cost of borrowing at historically low levels, it may be an advantageous time for families to consider this strategy. Because of the complex requirements, families can benefit from the help of a professional advisor or tax expert in making arrangements.