Using Intra-family Loans to Transfer Your Wealth

Most parents want to be generous with their adult children and provide them with support when needed. In fact, a recent survey by Savings.com found that nearly half (47%) of U.S. parents helped their adult kids financially, contributing to items such as vacations, paying off debt and household expenses.

Sharing your wealth with family members can be accomplished via an annual or occasional gift, transferring assets to a trust or providing a loan, depending on the amount involved and the circumstances.

“One of the most common reasons that parents choose to loan their kids money, instead of giving it to them, is to promote financial responsibility," said Nichole Walker, a senior wealth planner with City National Bank. “Many parents want to teach the next generation how to handle money, so repaying the money over a structured period of time can be part of that education."

Among high-net-worth families, a loan may sometimes be preferable to avoid tax repercussions from a gift, Walker added.

In 2024, IRS rules allow an annual gift of $18,000 from one individual to another without tax implications. In addition for 2024, individuals have a lifetime gift tax exemption of $13.61 million and married couples have a lifetime gift tax exemption of $27.22 million. However, these relatively high exemption amounts sunset at the end of 2025.

“If an individual is bumped up against his or her lifetime exemption, or wants to preserve that exemption to facilitate the transfer of some other asset, they may want to contemplate an intrafamily loan," said Walker. “An intrafamily loan may be forgiven at some point if circumstances change, so there is the flexibility to turn it into a gift that counts against the gift tax exemption in the future."

However, Walker said, it is extremely important that families do not prearrange an agreement to forgive the loan.

“If a prearrangement is in place, the IRS will consider the loan a taxable gift," said Walker.

 

What Are Intrafamily Loans?

Intrafamily loans are often made between parents or grandparents and their adult offspring, but an intrafamily loan can be set up between any relatives. An intrafamily loan can be used for almost any purpose, too.

They offer a flexible way to transfer funds to a relative since the borrower doesn’t need perfect credit or collateral for the loan.

As the lender in an intrafamily loan, you have the option to structure loan repayment in a variety of ways and you can choose whichever method works best for you and the borrower.

While you can draft the loan documents yourself, Walker said most people discuss their arrangement with their wealth planner, estate planner, tax advisor and an attorney before initiating the loan documentation process.

“As the lender, it is imperative that you document the loan. You may also want to establish a separate account to receive payments of interest and principal over the term of the loan. Make sure there is no ammunition to trigger an IRS reclassification of the loan as a gift," said Walker.

IRS Requirements & Intrafamily Loan Rates

While it may be tempting to do a "handshake loan" between relatives or handwrite an IOU note, it's essential to follow IRS rules and protocols for an intrafamily loan in order to avoid tax consequences.

The IRS requires intrafamily loans to have a written agreement that establishes a formal relationship between the lender and borrower. In addition, the family member lending the money must make sure the borrower can afford to repay the loan.

The IRS issues the applicable federal rate (AFR), which is the minimum interest rate that must be charged on intrafamily loans to avoid tax consequences. While the AFR rate changes each month, the rate for an intrafamily loan is fixed for the entire loan term based on the interest rate established during the month the loan closes.

The IRS provides AFRs that depend on the loan term and compounding method. Typically, AFRs are significantly lower than market rates for loans.

To view current rates, you can visit the IRS AFR page that is updated monthly.

In addition to charging at least the AFR, you must document the loan terms.

“You need to have a written document that shows the maturity date for the loan, the repayment schedule, the collateral for the loan and the principal and interest payments," said Walker.

Can Intrafamily Loans be Interest Only?

The flexibility of intrafamily loans allows you to structure them almost any way you prefer. However, there may be tax implications to your decision about how an intrafamily loan is repaid.

An interest-only loan with a balloon payment is allowed for an intrafamily loan, but as the lender, you need to follow tax laws.

“If you charge less than the applicable federal rate or no interest at all, the difference between what you charge and the federal rate will be considered taxable income," Walker said.

In addition, the loan could be considered a gift to the borrower and count against your annual gift tax exclusion or your lifetime gift and estate tax exemption.

 

How to Structure an Intrafamily Loan

When families choose to make an intrafamily loan, they must establish the terms of the loan in a written agreement or promissory note to be considered a true loan by the IRS.

Intrafamily loan terms that need to be established include:

• The interest rate, which must be at least the minimum AFR set by the IRS or higher.
• The length of the loan repayment period.
• The required monthly, quarterly or annual payments.

For a real estate loan, a lien should be legally established against the property.

The repayment plan can be structured in any way that works for the lender and borrower, such as with a principal-only payment, an interest-only payment with a balloon payment for the principal at the end of the loan or even a loan where the interest accrues and is paid along with the entire principal at the end of the loan period in one large payment.

Borrowers don’t pay taxes on a family loan, and they may be able to deduct interest charges on the loan from their federal income tax return.

However, the lender must report interest received on the loan as taxable income. Even if the borrower doesn’t pay interest, the lender will be required to pay income taxes on the imputed interest payments that are not being collected.

 

Why Consider an Intrafamily Loan

An intrafamily loan can be a financial lifesaver for individuals who can't qualify for a traditional loan because they lack trackable income that can prove their ability to repay a loan, have poor credit or don't have the income to pay a higher interest rate, said Walker.

“If parents or grandparents want to help their kids or grandkids buy their first house, an intrafamily loan can be a useful tool," said Walker. “I've seen it used as well to buy art, a car, or to make an investment in commercial real estate. Sometimes family members use an intrafamily loan to help their relatives start a business."

Other reasons to consider an intrafamily loan include:

• To help a family member pay down debt at a lower interest rate.
• To provide funds for a strategic investment.
• To take advantage of lower interest rates.
• To provide flexibility in loan repayment options.

According to Walker, the lower interest rates can make the difference in affordability for first-time homebuyers or other borrowers because the payments may be significantly lower than those at a standard commercial interest rate.

“Plus, family members can be more flexible on the repayment plan, with payments made annually or monthly or even, with an interest-only loan with a balloon payment, when the loan matures," said Walker.

Since the interest rates on an intrafamily loan are often lower than commercial rates, you can use one to facilitate an investment strategy, said Walker.

“In other words, someone can use the proceeds from the loan to make an investment that earns a higher return than the cost of the loan," said Walker. “That differential generates a profit and can be used to repay the loan. The excess profit can be kept by the borrower without any transfer tax implications."

While the main risk of an intrafamily loan is the possibility of having it reclassified as a gift if IRS rules are not followed, families also run the risk of non-payment by the borrower, Walker said.

If the borrower defaults on an intrafamily loan, the lender should attempt to collect the funds. If they choose to forgive the debt, the IRS will consider the funds a gift and that amount will count against the annual gift tax exemption or the lifetime gift and estate tax exclusion.

 

Consider Using an Irrevocable Grantor Trust

Some families may want to provide a loan to an irrevocable grantor trust for designated beneficiaries instead of a direct loan.

“Making a loan to the trust can be a good strategy because it allows the parents to remove an asset from their estate to benefit their beneficiaries," said Walker. “For example, if they want to loan funds to their child to facilitate an investment in real estate, they can loan those funds to a trust. If the trust earns a higher rate of return on the investment than the borrowed funds, the trust keeps the earnings without transfer tax implications. As long as the real estate is appreciating at a rate above the interest rate, it's tax-free growth."

In addition, any income or gains generated by the trust are taxed to the grantor, not the trust, so the assets in the trust are not depleted.

“Another benefit of providing an intrafamily loan to a trust is that the designated beneficiary gets asset protection," said Walker.

A City National Bank client chose to provide an intrafamily loan to a trust to facilitate the transfer of a franchise business to his children, said Walker.

“Instead of gifting the franchise outright, he transferred the business into the trust with 50% as a gift and 50% as a loan," said Walker. “That way the children have some skin in the game, and the payments are more manageable. The payments are made to the grantor while the asset continues to grow within the trust for the benefit of the beneficiaries."

 

Things to Consider Before Using an Intrafamily Loan

Before providing your relative with an intrafamily loan, it’s important to consider the legal, tax and financial implications of your decision.

Beyond those considerations, it’s also important to think about the potential for family conflict that could arise when you offer an intrafamily loan. Will every family member be treated equally? Will family members who are not offered an intrafamily loan feel excluded?

It’s also necessary to think about what happens if your family member defaults on the loan, which will have financial as well as personal consequences. Will this cause complications in your family relationships?

While loaning money to relatives does not have to be complicated, it's smart to consult your estate and tax advisors as well as your legal advisors first. That way, you're exploring what options for sharing your wealth with family might be best for your situation.