Low-Cost Alternative to Family Gifts: Lending
WALTHAM, Mass. (TheStreet) -- As long as we have a gift tax, people will try to find other ways to share their wealth with family members. Family loans have long provided a useful way for parents to help their children buy a house, make an investment or start a business.
Before 1984, when people made interest-free loans, the IRS tried to tax a market rate of interest on such loans as a gift. But the courts sided with the taxpayers until Congress closed this loophole by establishing a "market rate" for family loans. Basically, if you charge less than the market rate, the government treats you as if you did charge interest. The lender is taxed on this "imputed" interest and the uncollected interest is deemed a gift. If the borrower would have been able to deduct the interest, they are also entitled to deduct the imaginary interest they are considered to have made.
Rates are at an all-time low on family loans -- a gift from the government on what are sometimes gifts between family members. |
Rates are at an all-time low. The market rate is called the Applicable Federal Rate, or AFR. This rate is reset each month, based upon the yield on U.S. Government obligations. For December the rates are a paltry 0.32% for a loan with a term of three years or less. That's only $3,200 per year on a million-dollar loan. Longer-term notes carry a higher rate. If the loan is between three and nine years, the rate is 1.53%, and if it has a term in excess of nine years, the rate can be fixed as low as 3.53%.
Creative advisers recommend AFR loans for many purposes. Ralph Rotman, of
in Boston, says he has recommended low-interest loans to a trust used to buy life insurance "as a stopgap measure until we can find more permanent ways to fund the trust."
"As the AFR has come down we've been able to refinance family loans to reduce the rate -- for the same reason people refinance their mortgage," he says.
We have used interest-free loans as a way for parents to finance the children's investments. If the investment goes sour, the parent writes off the loan against their taxes, reducing the cost from the gift plus the tax to the loan less the deduction. At other times it is the children who want to help their parents. We have recommended low-interest loans from children to parents, sometimes secured by their homes, to provide necessary cash for living expenses. Parents, who are loath to take gifts from their children, may be willing to look at this as a business deal. Ultimately, the promissory note and security interest held by a child will protect their interest from Medicaid claims and allows the child to be first in line for repayment when the parents die or the property is sold.
There are limited exceptions to these rules. They don't apply to loans of less than $10,000, or to loans involving family farms below $1 million, and they never apply to arm's-length commercial transactions.
Finally, it's critically important to document the transaction fully and record all interest and principal payments carefully, or the IRS may assert the amount loaned was in fact a gift.
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