Intra-Family Loans: Securing a Lower Interest Rate in Today’s Environment

All good things must come to an end. That popular proverb can practically apply to anything in life – including low interest rates.

The historically low interest rates that we’ve known for a decade were swept out from under us in a matter of months. It’s amazing to think that not long ago, just over 25% of American homeowners refinanced their mortgages to take advantage of historically low interest rates. Flash forward, and everything appears to have turned upside down.

So, what changed?

To start, the Federal Reserve has been increasing interest rates drastically over the last year to tame the unusually high inflation we are all experiencing.

These increased interest rates don’t only apply to those seeking a mortgage. Individuals looking to take out a student loan, business loan, or any personal loan have found themselves paying more for these borrowed funds.

As a result, individuals are turning to family members for help when it comes to securing a loan. These intra-family loans are becoming an effective method to lock in a lower rate than what is offered through most traditional lenders, such as a bank. Not only may the interest rates be lower on these loans, but there are numerous other benefits to be had as well.

What is an intra-family loan?

An intra-family loan works just like any conventional loan that includes a borrower and a lender. Loans can be made directly from a parent or from any other family member. Loans can also be made through a family trust or even a family business.

An intra-family loan presents several opportunities for borrowers, including the opportunity to borrow funds at a substantially lower rate than through a traditional mortgage. Family loans can also provide more flexible terms and conditions that work in both the lender and borrower’s favor.

Here’s a quick summary of some pros and cons when it comes to using an intra-family loan:

Pros

• Borrower may benefit from friendlier terms and conditions
• Interest rates can be more favorable than traditional loans
• There are no lending fees such as administrative or closing costs

Cons

• May not be as easy to come by
• Can create relationship problems among family members
• Can trigger gift tax consequences if improperly structured

How is an intra-family loan structured?

Just like a conventional loan from a bank, an intra-family loan should be properly documented to include all terms and conditions. Key items to address in the loan agreement are:

• the duration of the loan,
• the interest rate, and
• a schedule for required repayments.

The borrower must abide by the repayment schedule. Any deviation could cause the loan to be disqualified in the eyes of the Internal Revenue Service (IRS) and could result in unintended tax consequences.

An intra-family loan can even be structured between an individual and a family trust. If the trust language allows for loans to be made and there are sufficient assets, a beneficiary may be able to borrow directly from the trust, providing access to a larger loan than they may have qualified for at a financial institution.

In fact, a loan can even keep a family trust’s portfolio in check by taking the place of a fixed income security. This is because the loan payments represent a stream of interest income for the trust over a period of time. However, a trustee has a fiduciary duty to manage the trust and must act in the best interest of the trust and all beneficiaries when considering a loan.

What lower interest rate can I charge?

Although family loans may offer friendlier terms, there are still strict payment rules that must be followed so the Internal Revenue Service (IRS) does not consider the loan to be a gift. One key factor is to make sure that for loans over $10,000, the interest rate charged is not less than the monthly applicable federal rate (AFR). The applicable federal rate is the minimum interest rate allowed by the IRS for private loans. Lenders can charge above the AFR, but not below without incurring tax consequences.

The interest rates are issued monthly and are determined by a variety of economic factors, including market yields of marketable debts, such as U.S. Treasury bills. AFRs tend to be much lower than rates available from a conventional lender. The current and historical rates (dating back to January 2000) can be found here.

The IRS categorizes loans based on their duration, including short-term, mid-term, and long-term. These are as follows:

• Short-term: Less than 3 years
• Mid-term: Between 3 to 9 years
• Long-term: Greater than 9 years

Most commonly, the standard applicable federal rate of 100% is used for intra-family loans. However, the IRS also publishes applicable federal rates at 110%, 120%, 130%, 150% and 175%. These rates are used for particular transactions including sale-leasebacks, charitable remainder trusts, and golden parachute payments. The IRS also further breaks these rates down based on their compounding period, such as monthly, quarterly, semi-annually, and annually.

What are the tax implications?

As one would expect, a considerable amount of tax implications should be addressed when it comes to family loans. First, the lender must recognize any interest income that they receive on their tax return. The IRS says that even if interest isn’t paid, imputed interest may need to be reported on the lender’s tax return.

The borrower may have the ability to deduct this exact same interest on their tax return. However, as with most things in the tax code, there are exceptions. To deduct this interest, the borrower must generally itemize their deductions and meet certain other requirements as well.

Special rules also exist for loans under $10,000. The IRS view these loans to be small enough that they do not require any imputed income. These loans are also exempt from the imputed income rules if the borrower’s net investment income (such as dividends and interest) for the year is $1,000 or less.

Are there any other tax implications to be aware of? Of course, there are!

If loan payments are not current or a loan is ever forgiven, any remaining balance on the loan could be considered a gift and chip away at your lifetime gift tax exemption. For 2023, this amount sits at $12.92 million per person. Even though that dollar amount may seem high, it is set to be cut in half starting in 2026.

Any gifts made in excess of $17,000 (in 2023) to an individual in a year reduces this exemption. Once it is used up, it could impact future estate tax liabilities.

Since individuals can gift up to $17,000 without any tax consequences, the tax code allows loan payments to be forgiven up to that amount. But keep in mind, the interest income may still need to be picked up on the lender’s tax return for the implied interest.

Implementing an intra-family loan

When it comes down to drafting an intra-family loan, it is best to seek out professional help. Working with a financial advisor and an attorney can help ensure the loan is appropriately structured, and that everything is accounted for correctly.

With the Federal Reserve anticipated to raise interest rates again before the end of the year, it is important to plan ahead. These rate hikes may even continue into next year, so establishing a loan now and locking in a lower interest rate could result in significant savings over the long term.

While intra-family loans can provide a great financial resource for a family member, it’s important to consider all aspects to determine if it is right for you. Family loans can strain family relations and should be carefully considered. As long as both parties stand by the terms of the loan, the benefits can be significant.