Using Intra-family Loans to Transfer Your Wealth

Most parents want to be generous with their adult kids and provide them with support when needed. A recent poll by found that nearly half (45 percent) of parents helped their adult kids financially. Sharing your wealth with family members can be handled with an annual or occasional gift, transferring assets to a trust or providing a loan depending on the amount of money 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, said Walker.

IRS rules allow an annual gift of $15,000 from one individual to another without tax implications. In addition, for 2021, individuals have a lifetime gift tax exemption of $11.7 million and married couples have a lifetime gift tax exemption of $23.4 million. However, the higher exemption amounts sunset at the end of 2025.

“If an individual is bumped up against his/her lifetime exemption or wants to keep that exemption to facilitate the transfer of some other asset, he/she may want to contemplate an intra-family loan," said Walker. “An intra-family 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.


Basics of an Intra-family Loan

Intra-family loans are often between parents/grandparents and their adult offspring, but an intra-family loan is possible between any relative. While it may be tempting to provide a loan with a verbal agreement between relatives or with a handwritten note, it's essential to follow IRS rules and protocols for an intra-family loan to avoid tax consequences.

“Extremely low interest rates make an intra-family loan even more appealing right now," said Walker.

The IRS issues the applicable federal rate (AFR), which is the minimum interest rate that must be charged on intra-family loans to avoid income tax or gift tax consequences. The rates decreased dramatically in 2020 and 2021 due to the Federal Reserve's actions in response to the financial turbulence created by the pandemic.

The IRS provides AFR rates that depend on the loan term and compounding method.

In September 2021, AFR rates were as follows:

  • 0.17% for an annually compounded short-term loan of three years or less.
  • 0.86% for a mid-term loan of three to nine years
  • 1.89% for a long-term loan of more than nine years.

These rates compares to 1.85%, 1.78% and 2.21% respectively in September 2019.

In addition to charging at least the minimum interest rate (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. “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.."

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.


Rewards and Risks of an Intra-family Loan

An intra-family 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 intra-family 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 intra-family loan to help their relatives start a business."

According to Walker, the low 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 intra-family loan are often lower than most 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 intra-family 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.


Intra-family Loans and Irrevocable Grantor Trusts

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 intra-family loan to a trust is that the designated beneficiary gets asset protection," said Walker.

One City National Bank client chose to provide an intra-family loan to a trust to facilitate the transfer 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."

While loaning money to relatives can be simple, it's smart to consult your team of estate and tax advisors to be sure you choose the most advantageous way to share your wealth with your family.

This document is intended to provide general information. It is not meant to provide specific tax guidance. The information in this document was compiled by the staff of City National Bank (City National) from data and sources believed to be reliable, but City National makes no representation as to the accuracy or completeness of the information. The opinions expressed, together with any estimates or projections given, constitute the judgment and opinion of the author as of the date of the presentation. City National has no obligation to update, modify, or amend this document or otherwise notify you in the event any information stated, opinion expressed, matter discussed, estimate, or projection changes or is determined to be inaccurate.

City National, its managed affiliates and subsidiaries, as a matter of policy, do not give tax, accounting, regulatory, or legal advice, and any information provided should not be construed as such. Rules in the areas of law, tax, and accounting are subject to change and open to varying interpretations. Any strategies discussed in this document were not intended to be used, and cannot be used for the purpose of avoiding any tax penalties that may be imposed. You should consult with your advisors on the tax, accounting and legal implications of actions you may take based on any strategies or information presented taking into account your own particular circumstances. Trust services are offered through City National Bank.