What is the most popular bank in the United States? Is it Chase? US Bank? Wells Fargo?
Nope!
The most frequented bank is much closer to home than that. That’s right, we are talking about BOMAD (also known as Bank of Mom and Dad).
Adult children have been known to use the BOMAD as a lifeline (like when their car is on the fritz, or when they get hit with an emergency medical bill). In fact, 59% of non-student adults aged 18-39 rely on their parents for some sort of financial assistance, according to Forbes.
Much of the time, the money in question is essentially being gifted. However, there are families that approach this in a more formal way. One method is by setting up loans, typically directed from the older generation to the younger generation. If done properly, this arrangement can offer tax benefits for both parties. However, mixing money and family carries a certain amount of risk.
Intra-Family Loans: A Use Case
There are many ways to shift money inside a family, including an estate plan, a sale of a business, a gift, and a loan (among others). Let’s look at the last two in detail.
First up, gifts. Families can give as a gift sums up to $15,000 per individual (or $30,000 per couple) per calendar year to anyone without having to claim it as income for taxes. There is no limitation on how that money is used (as long as it’s used for legal purposes, of course).
Next, let’s consider loans.
Suppose Mom and Dad lend $1M to their adult child. The loan is set up in a formal way, with an interest rate above the required minimum and with clear repayment terms (more on that in a moment). Let’s say the adult child turns around and invests that $1M in a way that pays him or her a return above and beyond the interest rate on the loan. In this situation, any appreciation in the value of the investment (beyond the interest expense) transfers to the adult child tax free.
What’s not to love, right?
Actually, not so fast.
Intra-Family Loans: A Note of Caution
Before you, our reader, get all excited and run out to set up an intra-family loan, read on for a bit of fine print. It is true that an intra-family loan can offer certain tax benefits. However, not every loan inside a family is automatically a good idea.
For one, it is not uncommon for the recipient to see the money as a gift while others in the family believe it to be a loan. As you might imagine, this can cause tension and strain relationships. It is important to consider every transaction inside the family as part of a bigger picture, carefully thinking through how it impacts each family member and their perception of what’s fair and right.
Additionally, the tax free transfer is related to the appreciation on the asset — not the full value of the asset. So, unless you have a significant amount of money at stake and an idea for how to generate a superior ROI, there may not be a solid use case in this strategy from the tax perspective. As a practical matter, a lot of “loans” that we see turn out to be gifts in disguise.
Side note: Applicable Federal Rate or AFR
The enforced interest rate is called the AFR, the Applicable Federal Rate. It varies from month to month. You may check the IRS website for the current month’s AFR. AFR rates have different tiers based on loan length and payment frequency. These rates are typically lower than rates you can find commercially.
intra-family loans
Tax Strategy: Intra-Family Loans
Intra-family loans are a means to minimize certain tax implications for both the lender and the recipient. However, it is important to evaluate the pros and the cons on paper — and to consider how this decision might affect relationships.
Advantages:
- For recipient: An opportunity to borrow money at a potentially favorable rate.
- For recipient and lender: A vehicle to transfer some of the estate to the younger generation tax free.
- For recipient: No limitations on the intended use of borrowed funds.
Caution:
- Be sure to set clear expectations. Is this a true loan, or is this a gift? Both parties must agree. If it is deemed to be a loan, it must be documented, it must have an interest rate at or above the Applicable Federal Rate, and it must include a repayment schedule. If it is a gift, that doesn’t make it a free-for-all; be sure to mind the gifting tax rules.
- Beware family dynamics. Parents have to be careful when helping one family member over others. That could potentially lead to hurt feelings, frustration, and bitterness inside the family.
- Stick to the agreement. If the IRS finds this to be a de facto gift not loan (for example, if the borrower doesn’t make the repayments), then there will be gift tax exposure on any amount that exceeded the allowed tax-free maximums.
- Mind the ROI. The returns on the money (whether invested or used for business purposes) should be greater than what you’re paying in AFT. Otherwise, the loan won’t generate favorable tax outcomes.
Savings Range:
- If properly documented and set up appropriately, the savings formula is 40% of appreciation on the asset above and beyond the AFT.
Good Business: Strategies to Make Intra-Family Loans Work
In closing, a few remarks.
- If you set up an intra-family loan, treat it seriously. Get it in writing. Define the interest rate, set up a payment schedule, and stick to the terms. If the family is going to play bank, it may as well act the part!
- Be financially and mentally prepared for the risk that the borrower never pays you back. That includes whatever gift taxes may get triggered as a result of reclassifying the loan into a gift.
- Know your family and be fair. Offer similar opportunities among family members if possible, so that there is no fear of playing favorites.
Here at TreMonte, we can help you figure out if your situation would benefit from incorporating an intra-family loan into your financial plan, and how to do so properly. Reach out to a member of our team today!
Photo by Karolina Grabowska on Pexels