With interest rates at abnormally low levels, it may be time to take advantage of the current situation. A loan to a family member, called an intra-family loan, is one method to transfer a benefit to a family member and take advantage of the tax laws at the same time.
First, some basics regarding imputed interest. Back in 1984, when interest rates were much higher than today, Congress decided to stop a perceived abuse of manipulating interest rates on loans. The result was a set of rules that require that interest be “imputed” on loans that don’t provide for sufficient interest by the terms of the loan.
The minimum interest rates are published each month by the IRS and are broken down for short-term loans (three years or less), mid-term (over three years but not over nine years), and long term (over nine years). These interest rates are referred to as Applicable Federal Rates, or AFR.
The imputed interest rules don’t change the terms of an intra-family loan, only the character of the payments. For example, if a loan for $100,000 provides for ten annual payments at 0% interest, a portion of each $10,000 payment would be treated as interest by the borrower and lender if the imputed interest rules apply, and the lender would need to count that amount as interest income. Not all loans are subject to these rules, but most loans between related parties are.
As a result, a little bit of creativity can yield benefits to family members who are the recipients of the intra-family loans. Here are some examples (the rates mentioned are for June 2015):
Intra-Family Loan for Home Purchase or Refinance:
Current mortgage rates are about 4% for a 30-year home loan, plus loan origination and closing costs, and the long-term AFR is currently 2.5%. A parent or grandparent can use an intra-family loan to provide an adult child the money needed for a first-time home purchase and lock in the 2.5% rate, making it a less expensive way for the child to finance the home.
For example, the payment for a $200,000, 30-year loan at 4% is $955, compared to $790 for a 2.5% loan, or $556 for a 0% loan with interest imputed at 2.5%. In order for the borrower to deduct the interest paid or imputed on the loan, the loan must be secured by the home.
Investment in Asset with Higher Rate of Return:
The 5-year imputed interest rate is currently 1.52%. A five-year loan to a child for investment purposes would need to only carry an interest rate of 1.52%, or the loan could be at 0% with annual interest imputed at 1.52%. In addition, for a 0% gift loan up to $100,000 such as this, the imputed interest is limited to the borrower’s net investment income. The borrower may be able to deduct the interest as investment interest expense as an itemized deduction. This type of arrangement can increase a younger family member’s net worth by leveraging the senior generation’s funds.
Buy In to Family Business or Rental Property:
Low interest rates mean cheap financing for a child wanting to buy in to a family business or rental property. A purchase combined with a gift of a minority interest may allow the investment to pay for itself from cash flow generated by the business. For example, if the interest in the business being transferred is worth $200,000 and half is transferred to a child by way of gift, the other $100,000 could be financed at 2.47%. Over 10 years, the monthly payment would be $941. At 0% interest, the monthly payment would be $833 with imputed interest. In this transaction, the seller needs to be aware that the sale portion of the transaction may create gain on the seller’s tax return, and the sale of depreciable property to a related party will convert capital gain into ordinary income.
Loans between related parties should be documented in writing and records of payments should be maintained. Also keep in mind that the lender in a loan transaction will have interest income, even with a 0% loan. It’s a good idea to run any transaction by a knowledgeable tax person prior to entering into an agreement, even with family.
Cecil McPherron, CPA