One of the most flexible and powerful gifting techniques is to loan money to other family members, especially in a period of low interest rates. The reason it works is simple: on average, the person receiving the loan should be able to invest the money received in a way that produces a rate of return greater than the interest rate on the loan. Thus, when the borrower returns the loaned money at the end of the loan’s term, they will be able to keep this excess return. Because the money was loaned, and not gifted, this excess is tax-free, and you have managed to transfer property to the borrower without paying gift tax.
Once, it was possible for you to make an intra-family loan without charging any interest. Ultimately, however, Congress decided that this was too good of a deal and passed laws to force family loans to look more like commercial loans. The IRS now divides loans into three durations based on their term: short (less than three years), mid (three to nine years), and long (more than nine years). An “applicable federal rate” is published each month, setting the interest rate for each of the three durations. Most intra-family loans use the mid-term rate, and are nine years in duration, but the best structure obviously depends on the interest rates for that month and other family issues (such as when the lender needs to be repaid for their own cash flow issues).
The most straightforward way to loan money is simply to extend the loan directly to the family member who needs it. For larger loans, however, some will make the loan to a family trust instead of directly to an individual. In addition to some income tax advantages (discussed below), this has two principal benefits: (1) it grants parents greater control over the funds that are loaned, and (2) it enables greater flexibility in retaining access to the funds.
Consider the example depicted below:
Husband loans the trust $1.0 million for a term of nine years, which the trust presumably invests (in securities, real estate, a family business, etc.). The trust owes this money to husband and must make regular payments on the note. By the end of the nine-year term, husband has been returned all his original $1.0 million. Any property left in the trust, however, gets the following benefits:
The income tax consequences of an intra-family loan depend on who the borrower is. If the borrower is an individual, then the interest on the loan is income to the lender. The interest may or may not be deductible to the borrower, depending on the purpose of the loan.
If the loan is to a trust, however, there may not be an income tax consequence. If the trust is a so-called “grantor trust” (as the family trust shown above would be), then the trust is considered to be the same income taxpayer as its creator. This means that the while interest on the loan must be paid, it produces no income tax impact at all, because the lender and borrower are using the same tax ID number and filing the same return.
It is very important that all loan formalities be respected and the debt be paid. It must be properly documented with a promissory note, and payments should be made according to its terms. To that end, it is also important that the borrower can repay the loan. For example, if the loan is to a trust, it would be advisable to ensure that the trust has other assets, in addition to the funds being loaned. Many experts suggest at least a 9:1 debt to equity ratio in the trust, in which equity could be added by gift or accomplished by using a pre-existing trust that had previously been funded. These steps that carefully establish that this loan is “real” should help avoid the primary gift tax risk: that the IRS will conclude the loan was really a disguised gift, and that the entire loaned amount may be subject to a 40% federal gift tax immediately (if the “lender” has no remaining federal lifetime gift exemption).
The other principal risk of the technique is an investment risk. The loan must be paid back regardless of the performance of the loaned funds. If these decline in value (e.g., they are invested in a building and there is an uninsured fire on the premises), the borrower must still somehow pay back the loan. If the loan is forgiven, this will be a gift and subject to gift tax.
The technique’s effectiveness is entirely dependent on the return on the invested funds. The following chart assumes a nine-year loan of $1.0 million. The loan provides for annual interest-only payments with a balloon payment at the end of the nine-year term and funded in a month in which the applicable federal mid-term rate is 5%. The chart below shows the way investment performance drives the technique: at higher returns, the power of compounding transfers more than 80% of the original loan amount tax-free, while a 5% return produces no benefit at all.