An intrafamily loan is a financial arrangement between family members—one who is lending and another who is borrowing. An intrafamily loan may be used to help a family member who needs money to:
- Buy a home.
- Fund or purchase shares in a business.
- Add accounts or property to investment portfolios.
- Pay down high-interest debt.
- Cover educational expenses.
What is an Intrafamily Loan?
Lending to a child or grandchild can be satisfying. Your loved ones can benefit from flexible repayment terms and interest rates while learning financial responsibility. This can be beneficial if the child or grandchild would otherwise have difficulty obtaining a loan through more traditional methods. It also gives you an opportunity to add to your investment income.
When You Should Consider an Intrafamily Loan
How you give or loan money to family members has potential tax implications. The right method depends on your family circumstances.
An intrafamily loan might be beneficial in estate planning for wealth transfers between generations while minimizing estate tax implications. Further, by using an intrafamily loan to provide money to a family member rather than making a gift, you can maintain control over the principal amount and how it is used.
Intrafamily loans are valuable tools for preserving wealth and offer the following advantages:
Flexible Interest Rates with Intrafamily Loans
With intrafamily loans, you have the flexibility to set the interest rate at a level lower than commercial lenders if the rate is not below the Applicable Federal Rate (AFR) (read below for further discussion on the AFR). The cost savings for the borrower can be significant. Further, if the AFR is high when you initially make the loan, it may be easier to reissue the note from you to take advantage of any future lower interest rates than it would be to refinance a note from a third-party lender.
Family Business Succession
Intrafamily loans can play a crucial role in transferring a family business from one generation to the next. By providing financing to family members who wish to take over the family business, for example, you can ensure a smoother transition and help sustain the family legacy.
Determining the US Interest Rate to Use with an Intrafamily Loan
Determining the interest rate for your intrafamily loan is crucial to avoid unnecessary tax consequences. The Internal Revenue Service (IRS) publishes AFRs monthly, broken down into three tiers for short-term, mid-term, and long-term rates. Rates can be fixed or variable and structured to the advantage of both parties. The minimum AFR rate must be charged for loans over $10,000 regardless of a loved one’s credit rating, and it is usually lower than most commercial lenders.
If the interest rate for your intrafamily loan is below the AFR, the IRS may require you to pay income tax on the income you should have received under the applicable AFR even though the borrower did not pay you that amount (called imputed interest). Also, the amount of interest you did not collect but should have may also be considered a taxable gift to the borrower, potentially reducing the amount of gift and estate tax exemption available to you.
Documenting Intrafamily Loan Terms
Since the IRS generally assumes that wealth transfers between family members are gifts, it is essential to have the proper documents showing that the transfer is intended to be a loan. You and your family member must sign a promissory note that adheres to the state-specific rules to properly document the loan transaction.
Is an Intrafamily Loan Right for You?
Every financial decision has the power to strain family relationships. When trying to determine if an intrafamily loan is right for your situation, ask the following questions:
- Will lending to one child appear unfair to others?
- Should various loan types be considered for different children based on their personal situations?
- If the child is unable to pay off the loan, will a loan default cause family friction?
- Will the loan be forgiven at my death, or will it be considered a debt owed to my estate or trust? In either case, how would that affect the other children?
About Skvarna Law Firm in Glendora and Upland, California
Skvarna Law Firm operates offices in Glendora and Upland, California. We provide legal services. We cover San Bernardino, Los Angeles, Orange, and Riverside Counties. This includes several cities. Upland, Ontario, Rancho Cucamonga, Fontana, Colton, Rialto, Chino, Chino Hills, Glendora, Claremont, Pomona, La Verne, Montclair, San Dimas, Azusa, Covina, West Covina, Diamond Bar, Walnut, La Puente, Corona, Norco & Mira Loma. Visit SkvarnaLaw.com to learn more.
