There are times when your children need help. When that help is financial, an intra-family loan could be the answer – but you have to do it right!
When loaning money in excess of $10,000 to a child (or any related party), the IRS says it must be structured as a bona fide loan.
That means you need to charge interest of at least the “Applicable Federal Rate” (AFR) set forth by the IRS each month. The required rate varies based on the loan’s term, whether short-term (0-3 years), mid-term (3-9 years) or long-term (greater than 9 years). In any case, the AFR rate is typically well below what’s available on the market.
Consider this example. Mark and Lauren have a son Johnny who runs a successful restaurant.
Johnny wants to expand and needs capital for the remodel. He estimates the remodel and downtime will cost $50,000. Unfortunately, due to his minimal credit history a bank loan would need to be repaid within five years at an interest rate upwards of 7 percent. Johnny’s parents are willing to make the loan with a term of ten years at a rate of 3.5 percent. Since the long-term AFR is 2.18 percent, the IRS would be satisfied and Johnny would be able to move his business forward.
A second example of an intra-family loan would be if a child needed alternate or additional financing on her home.
Under the current mortgage environment, the child might not be able to refinance through traditional channels. Here, a parent could choose to be the lender instead of a bank. As a long term intra-family loan, the interest rate would again need to be at least 2.18 percent. And, as long as the loan is secured on the home, interest paid on the intra-family loan would be tax deductible to the child just as a mortgage from the bank.
Just know the IRS presumes that any transfer of property between family members is a gift unless the lender can prove that the transaction is a bona fide loan.
So, in addition to adhering to the interest rate rules, you should have a written promissory note with a fixed payment schedule and security, as applicable. If the loan is not structured properly, the IRS could characterize it as a gift. While drafting the note yourself is possible, we recommend consulting an experienced attorney to ensure your loan is structured properly. For more information on this topic, please contact us at Rowling and Associates.