The recent decision by the Federal Reserve to lower interest rates by a half-point will bring relief to many borrowers, reducing the cost of mortgages, loans and credit cards.
Most people do not know that the IRS also sets minimum interest rates for loans between family members and others they consider related parties, and these rates have also been reduced.
Let’s explore what that means for your family.
Benefits of loans to family
Interfamily loans can be a powerful financial tool for several reasons. They allow transfers of wealth without triggering gift taxes, and if an asset is purchased with the loan, it could appreciate at a rate higher than the loan’s interest rate.
This creates an opportunity for the borrower, generally an adult child, to build wealth when a down payment for a home or seed money for a business is not readily available.
Additionally, interest payments stay within the family rather than going to an external bank, also preserving family wealth.
For family members with poor credit ratings or for funding non-conventional investments and start-ups, interfamily loans could be their only source of funding.
Lastly, these loans can offer lower closing costs, more flexible terms, and reduced funding delays associated with traditional bank loans.
Beware of related party rules
You must be careful when loaning money to family members, because the IRS scrutinizes them to prevent tax evasion.
The IRS requires that “related party” transactions be treated like any other business deal with an unrelated party, requiring proper documentation and market-based terms.
Related parties include individuals or entities with close connections that may influence transactions, like family members, a corporation and its majority shareholder (and the shareholder’s family), commonly owned entities (including partners in multiple partnerships), or an executor and beneficiary of an estate.
For a related-party loan to be recognized as a legitimate loan by the IRS, it must be structured similarly to a loan you would receive from a bank.
This means the transaction must reflect an “arms-length” arrangement, where the terms and conditions mirror those set by an independent third party, and the loan must be adequately documented.
Determining the interest rate
The first rule is that you must charge a market rate of interest on the loan.
The correct rate might be difficult to determine, but thankfully, the Applicable Federal Rate is easy to look up. The AFR is the minimum interest rate the IRS requires for private loans to avoid tax consequences. The IRS publishes AFRs monthly, based on government security market yields. You can find the interest rate tables at irs.gov/applicable-federal-rates.
If a loan between related parties charges no interest or an interest rate lower than the AFR, it could trigger an audit. The IRS could impute an interest rate, add the interest income to the lender and tax it. Penalties and interest could be charged for not reporting the interest income.
How to make a related party loan
Suppose you would like to loan your adult child $148,000 to help with the down payment on a new home.
Here are the requirements:
—A legally binding promissory note stating the loan amount ($148,000) and the repayment terms, ideally prepared by an attorney and notarized;
—A clear repayment schedule outlining the payment amounts, due dates and duration of the loan. For example, the loan could be structured to be repaid over 20 years with monthly payments;
—The loan must charge an interest rate equal to or higher than the Long Term AFR (4.03% compounded monthly as of October 2024);
—State that the loan is not a gift and that you expect repayment according to the agreed terms.
—The child must make regular payments per the repayment schedule to reinforce that this is a loan, not a gift. However, you can gift funds annually to help the child make payments;
—Both parties should keep records of all payments made and received, ensuring accurate tracking of the loan transaction.
By following these guidelines, the loan will be appropriately documented and treated as an arm’s length transaction for tax purposes.
If a taxpayer does not appropriately follow the rules, the IRS can reclassify the loan as a gift.
Gift tax returns would need to be filed, and the gifts would use up some of the lender’s lifetime estate tax exemption. If the lender has passed away and there is a taxable estate, the gifts could generate an estate tax at 40% of the value of the loans.
When is a gift better than a loan?
A gift may be preferable when the lender doesn’t require interest income or the funds returned. If it’s unlikely the borrower can repay, or the lender plans to forgive the loan, gifting is simpler.
Like loans, gifts are not taxable to the recipient.
Gifts also offer estate tax benefits, as they are removed from the lender’s estate. Gifts under the exclusion amount ($18,000 in 2024 and $19,000 in 2025) and some exempt gifts, like tuition or medical expenses you pay for someone, do not require a gift tax return to be filed.
Additionally, gifts avoid the need to report taxable interest or keep track of loan payments.
You and your spouse can each give to your family member and their spouse, effectively multiplying the annual gift amount by four. (You and your spouse gifting to the family member and their spouse.)
This could turn an $18,000 gift into a $72,000 gift ($18,000 times four). If you gave at the end of this year and the beginning of next year, the multiplied gift would be $148,000 ($18,000 times four in 2024 plus $19,000 times four in 2025), which is the amount you were going to loan. Therefore, a loan might not be necessary.
Legacy planning
We advise clients to transfer wealth by combining family loans and annual gifts. By making loans for more significant investments and also gifting up to the annual exclusion amount, your children can use the yearly gifts to pay back their loans to you or, if they are doing well, for other personal goals.
In our example above, the payments on the $148,000 loan would be about $900 a month ($10,800 a year). A parent could give $18,000 a year, with $10,800 of it to repay the loan, while the remaining $7,200 could be used for something else.
This type of legacy planning can help your children and grandchildren achieve financial security and allows you to see the positive impact of your generosity while you are still here. The goal is to set up your family for lasting success and create a legacy that endures for future generations. What a joy to watch!
Michelle C. Herting is a CPA, accredited in business valuations, and an accredited estate planner specializing in succession planning and estate, gift, and trust taxes.
