Lending money to family members not only helps them out financially, but can be a tax-effective way to transfer wealth to the next generation.
Lending rather than giving allows you to provide wealth to the younger generation without totally parting with the money. You can hold on to your retirement nest egg, while encouraging financial responsibility among your heirs.
When you lend money to family members, be sure to charge a rate of interest at least equal to the applicable federal rate (AFR). A lower interest rate can trigger adverse income and gift tax consequences.
The wealth transfer occurs when the younger generation invests the borrowed funds and earns a rate of return greater than the federal rate. When the borrower repays the loan plus interest, the borrower keeps the spread between investment returns and the interest cost – without gift or estate taxes applying. Lower market rates of interest have kept the AFRs relatively low. So investment returns can outpace the interest rate on the loan.
Federal interest rates are published monthly and vary based on whether the term of the loan is short-term (3 years or less), mid-term (3-9 years), or long-term (9+ years). The AFR also varies depending on how frequently interest is compounded.
The loan balance itself is an asset to your estate. If you die before the loan is repaid, the borrower must still repay the loan to your estate, unless you structure the loan to have it forgiven if you die before it is paid off.
The downside of an intergenerational loan is the risk that the borrower’s investments will not outperform the AFR. There is also a tax risk that the IRS might challenge the loan as a disguised gift. To avoid this, treat the transaction as a legitimate loan.
Finally, document the loan with a promissory note containing enforceable terms. If your heir is unable to make a payment, you should make a genuine effort to collect the funds.
Davis & Hodgdon Associates has been assisting businesses and individuals in the Burlington Vermont Metro area for more than 20 years. If you have any questions or concerns please feel free to call 802.878.1963 or email [email protected].