Why an Intra-Family Loan May Be a Good Way to Transfer Wealth Right Now

With interest rates at historic lows, the intra-family loan is an attractive option for avoiding estate tax penalties

The economic downturn caused by the COVID-19 pandemic ushered in new considerations for estate plans and wealth transfers. Record-low lending rates coupled with promises from the Biden administration to not only undo the Trump tax cuts but “restore taxation to 2009 levels” are altering strategies.

If you’ve been contemplating using an intra-family loan as a vehicle for transferring assets and safeguarding them from increased estate taxes, now is a good time to do it. Interest rates are likely to rise as the economy gains steam and inflation concerns grow, and a Democratic Congress may successfully pass President Biden’s proposed tax hikes.

A creative alternative

Former President Trump’s signature tax legislation gave the U.S. taxpayer extremely favorable federal gift and estate tax rules. Under the current tax code, the estate and gift tax exemption for 2021 is $11.7 million for individuals ($23.4 million for married couples). Gifts that exceed the exemption rate are taxed at 40%. If left in place, the current exemption limits will expire in 2025.

For some taxpayers, including those whose estate planning goals include gifting more than the existing limits, the intra-family loan has many features that make it a viable means of transferring wealth:

  • The loan interest rate is set at the lowest rate the IRS allows, usually much lower than those available through commercial lenders.
  • The interest rate is determined using a formula set by the IRS (listed in the Applicable Federal Rates table) and is not dependent on other variables such as the borrower’s creditworthiness. This allowable rate reflects current interest rates overall—which are hovering near historic lows.
  • A loan is not subject to any preapproval process or underwriting.
  • The family member sets the terms and can dictate the manner of payments.

The intra-family loan can be used for any legal reason; it is treated like a line of credit with no mandated purpose. For example, a common use of intra-family loans is to allow family members lacking in liquidity to purchase shares in the family business. Also, it can be used to buy property with more favorable terms than available with conventional mortgages.

An intra-family loan provides the recipient an alternate form of funding with more favorable terms than those available anywhere else. When used to finance a major purchase, the advantages of removing commercial lenders from the equation are obvious. 

Transferring assets through low-interest loans also benefits parties if the funds from the loan are then reinvested in a higher-return opportunity and continue to build intergenerational wealth.

The mechanics of intra-family lending

The intra-family loan that fits all tax code requirements is a formally structured agreement with the interest rate specified in the appropriate AFR table. These interest rates, determined by a formula that weighs a variety of economic factors (including prior 30-day average market yields of U.S. Treasury obligations), are “at or near historic lows” because of the economic downturn brought on by the pandemic. 

As of May 2021, the compound annual applicable federal rate (AFR) is 0.13% for a short-term period (three years or less), 1.07% for mid-term loans (more than three years on up to nine years), or 2.16% for a longer term (more than nine years). In comparison, the long-term AFR was 2.7% in 2019 and 4.38% in 2010.

Obviously, the loaned funds can be put toward investments with a potential yield that beats those interest rates. And as long as the parties involved adhere to a formal loan agreement that specifies an interest rate charged at or above the AFR for the loan term, they can structure the loan in any way that fits their needs. 

Other considerations

The intra-family loan offers tax benefits for the lender and a way to attach accountability to an inheritance. Rather than simply gifting assets to family members, a formal loan allows the receiving parties to feel involved in a business transaction rather than getting a handout. 

The psychological component of rebranding a wealth transfer as a loan should not be overlooked. A good way to safeguard against emotional fallout is to make sure the terms of the loan align with the needs and goals of all parties. Agree upon and clearly describe the consequences for failure to meet reasonable loan repayment requirements. And lenders can be careful to avoid favoritism among family members by crafting similar arrangements with each loan recipient. 

It is also essential to follow all relevant regulatory guidelines and establish a paper trail in case of an audit.  

Growing and maintaining intergenerational wealth can be a challenge. But the intra-family loan offers a valuable tool to do it.

Making strategic decisions is easier when working with professional advisors tuned into the political and regulatory environment. Getting professional advice is often advisable when managing the complexities of intergenerational wealth—and Lindberg & Ripple is here to help.

Lindberg & Ripple features a team of experienced wealth advisors who can assist with managing the complexities of planning for retirement and complying with changing regulations. We’ll help you develop and maintain a customized plan designed to grow and preserve wealth for future generations. Contact us to learn more.

 

This material should not be construed as legal or tax advice and is not intended to replace the advice of a qualified attorney, tax advisor or plan provider. Securities and Investment Advisory Services Offered Through M Holdings Securities, Inc. A Registered Broker/Dealer and Investment Adviser, Member FINRA/SIPC. Lindberg & Ripple is independently owned and operated. File # 3616708.1