Lending money to family members can be a very effective way for wealthier family members to help less wealthy family members buy homes, start businesses or get out of debt without the burden of outright gifting. There are rules they must be followed or the loan could be treated by tax authorities as a gift.
First of all, interest must be charged at the federally mandated rate, known as the Applicable Federal Rate (AFR). The IRS sets the AFR as the minimum interest rate allowed for private loans. These rates are published monthly on the IRS website. Each month the IRS publishes 3 AFRs: short-term, mid-term and long-term rates and the term of the loan must correctly correspond to the AFR. If the interest on a loan is lower than the applicable AFR, it may result in a taxable event for the parties involved.
The 3 AFR terms are defined as:
Short-term: term is less than 3 years
Mid-term: term is up to 9 years
Long-term: term is more than 9 years.
Due to economic issues resulting from the COVID19 pandemic, the rates in April 2020 for a short-term loan were 1.18% and were lowered by the IRS in June 2020 to 0.23%. This is still well below bank loan rates and can help a family afford a home or business investment that could not otherwise be secured by traditional lenders. It may also simply be used to assist family members struggling with financial issues resulting from the pandemic.
The lender and borrower must construct the loan using the AFR that is published by the IRS at the time when the lender initially makes the loan. With such low rates, now may be the right time to consider making an intra-family loan to spread liquidity among family members.
The first $15,000 could be given as a gift and any amount above that structured as an intra-family loan. The IRS’ annual gift exclusion permits a taxpayer to gift up to $15,000 annually to each family member without penalty. Essentially, an individual could gift $15,000 to every person they know, but once any one gift recipient receives more than $15,000 from an individual donor in the calendar year, that donor must file a gift tax return. See IRS Publication 559
To discuss how to take advantage of the low AFRs by incorporating intra-family loans into your overall estate plan, contact Stouffer Legal at 443-470-3599 in the Greater Baltimore area.