It's a common situation, even for young adults who are succeeding on their own, post-college: Asking if mom and dad can help out financially for a specific need, whether it's a down payment on a first house or helping pay off some lingering student loan.
The good news is that providing a family member with a loan can be helpful to both the recipient and you. But there are things you need to be aware of in terms of structuring the loan to make sure it works for everyone — including the Internal Revenue Service (IRS).
"Intra-family loans can be a solution for parents who'd like to help a child achieve specific goals, such as buying a home or starting a business, but would also like the child to have some personal responsibility, or 'skin in the game,' that the child wouldn't have if the parent simply gifted the funds to the child," says Anthony Fernandez, Senior Wealth Planner for the Northeast Region of Wells Fargo Private Bank in Summit, New Jersey. Of course, the loan doesn't have to be from a parent to a child. It could go the opposite way as children help care for aging parents, or between other family members.
Here, Fernandez gives families a primer on opening their pockets for very personal loans.
Interest rates' green lights
The minimum interest rate charged on intra-family loans is known as the Applicable Federal Rate, or AFR. It's published monthly by the IRS and is typically lower than the rate your child would be paying if he or she obtained a commercial loan, explains Fernandez. Though interest rates have risen a bit in the past year, they're still attractive, with a reduced burden on the child and minimal to zero closing costs and fees.
According to the Index of Applicable Federal Rates (AFR) Rulings, as of February 2016, the minimum rates were:
- 0.81 percent short-term, for loans with a term of up to three years
- 1.82 percent mid-term, for loans with a term of more than three years but no more than nine years
- 2.62 percent long-term, for loans with a term of more than nine years
It's important to have the right supporting documents and terms in place for a true intra-family loan; otherwise, the IRS may treat the move as a gift. If the borrower's circumstances suggest that he or she might not be able to repay the loan, for example, an intra-family loan may not be respected as such. "The loan should be structured and administered to demonstrate that a bona fide debtor-creditor relationship exists," says Fernandez, "and that there is a real expectation of payment."
The following items can help to make the loan official:
- A promissory note
- A fixed repayment schedule
- A fixed interest rate at least equal to the AFR for the month in which the loan is made
- Requested collateral from the borrower
- Records of payments
Wealth transfer strategies
While these types of loans are most commonly thought of for an important purchase for the child, there may also be other times when the loan makes sense, Fernandez says.
"Intra-family loans can also have wealth transfer benefits," he adds. "If the borrower invests the loan proceeds to earn a total rate of return that's higher than the interest rate being paid on the loan, then the difference remains with the borrower without a gift or estate tax consequence."
As an alternative to lending to them directly, parents or grandparents might consider lending to a trust for the benefit of the younger-generation family members. A note might provide for interest payments only, with a balloon payment of principal due at the end of the term. "If structured properly," says Fernandez, "a trust can provide creditor protection, wealth-transfer tax benefits, and better asset management for the funds and other assets that remain after the loan is paid."
Relationship red flags
Despite the potential benefits, intra-family loans aren't always the best solution. Even if your child is a golden apple rather than a bad seed, things can go rotten when it comes to big sums of money. "Entering into a business transaction, such as a loan, with a family member, can sometimes put a strain on the relationship, particularly if the borrower has trouble repaying the loan," says Fernandez. That's why it's always important to have family discussions about the arrangement first and think critically.
"Before entering into a loan, the family members involved should make sure they are comfortable with it from a family dynamics perspective."