What About Intra-Family Loans? October 21st, 2011
What is an intra-family loan? An intra-family loan is a loan from one family member to another. A typical example is a loan from a parent to an adult child. For example, John is a school teacher who also tends bar on Friday and Saturday nights at a local restaurant. He and his wife, Ruth, just had their 3rd child and they need to add an addition to their home so that they can build a nursery. John’s father, Daniel, offers to extend a $30,000 loan to John to be used for this home improvement.
Should the Loan be Documented? Despite the fact that a loan is between close family members, it definitely should be documented. There should be a promissory note, a loan disbursement statement, and the payment of any governmental stamps or taxes on the Note. In many instances, there should be collateral for the note, such as a mortgage or other security agreement. The lending family member’s estate planning attorney should prepare the documents. Further, the borrower should have the opportunity to have the proposed loan documents reviewed by a lawyer of his choice.
What About the Interest Rate? Many times family members wish to give interest free loans. Generally, this is a bad idea. With limited exceptions, interest free loans will result in taxable gifts of the imputed interest that was not charged. These gifts would then need to be reported on gift tax returns. Fortunately, the tax law allows for safe harbor interest rates for intra-family loans, called the Applicable Federal Rate (“AFR”) that avoids the gift imputed interest. The Internal Revenue Service publishes these rates monthly. The AFR for intra-family loans originated in November 2011 are:
0.19% per year for loans for 3 years or less;
1.20% per year for loans greater than 3 years and up to 9 years; and
2.64% per year for loans greater than 9 years.
These rates are substantially lower than those currently quoted by banks.
What About Repayment? The lending family member must have a reasonable expectation of repayment of the interest and principal, otherwise there is risk that the loan will be re-characterized as a taxable gift. In short, the lender must assess the borrower’s credit worthiness and collateral, if applicable, prior to extending the loan.
Can an Intra-family Loan be Interest Only? Yes, an intra-family loan can be interest only and balloon at the end of the term so long as the lending family member has a reasonable expectation of repayment.
What Happens When the Lending Family Member Dies? If there is an intra-family loan outstanding at the time of the death of the lending family member, then the note receivable is part of his estate. The borrower is required to make the note payments to the Personal Representative of the estate during the probate administration and thereafter the borrower makes payments to the assignees of the note. In many instances, the borrower receives other assets from the Estate and uses these assets to satisfy the Note in part, or in whole.
Note: This blog is designed for general information only. The information presented at this site should not be construed to be neither formal legal advice nor the formation of a lawyer/client relationship. If you would like to contact Stuart A. Rader regarding an area of probate and trust administration, estate planning, taxation, and succession planning for closely held businesses, please email firstname.lastname@example.org.