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Wealth Planning Advisory 3Q17

Using Intra-Family Loans as a Wealth Transfer Strategy

One of the primary strategies for making lifetime transfers to family members is outright gifts. Outright gifts require relinquishment of full dominion and control over the gifted property, and they may have gift tax implications.

An alternative to outright gifts to family members is intra-family loans. If properly structured, intra-family loans will not result in any gift tax consequences, or the relinquishment of wealth by the family member making the loan.

A loan to a family member requires that a minimum interest rate (Applicable Federal Rate) be charged. For example, the Applicable Federal Rate in July 2017 for a 10 year term loan with quarterly payments is 2.57%.

If loans to family members do not charge the Applicable Federal Rate, there are gift and income tax consequences. Interest will be imputed to the extent that the Applicable Federal Rate exceeds the actual interest rate on the loan. From an income tax perspective, the imputed interest is treated as income paid by the borrower to the lender. For gift tax purposes, the lender is deemed to have made a gift of the imputed interest to the borrower.

The two main exceptions to the imputed interest rule are: (1) when the aggregate outstanding loan balances between the lender and the borrower do not exceed $10,000, and the loan proceeds are not directly attributable to the purchase or carrying of an income producing property by the borrower, and (2) if the aggregate outstanding loan balances between the lender and the borrower do not exceed $100,000, the imputed interest for income tax purposes is limited to the borrower’s net investment income for the taxable year. Comment: Under a De Minimis Rule, the imputed interest is zero for income tax purposes if the borrower’s net investment income for the taxable year does not exceed $1,000.

One of the key advantages of an intra-family loan is the ability to shift wealth to another family member gift tax-free. For instance, the income and appreciation earned on the investment of the loan proceeds by the borrower in excess of the Applicable Federal Rate on the note shifts to the borrower without any gift tax consequences.

Finally, the IRS closely scrutinizes intra-family loans to make sure they are bona fide. One of the primary requirements for a bona fide loan is that the lender and borrower have a reasonable expectation for repayment of the loan. In other words, there cannot be a pre-arranged plan to forgive the loan. A pre-arranged plan to forgive the loan will result in an upfront gift of the loan proceeds.

This Planning Advisory is not intended as tax or legal advice. Also, it is not intended to offer penalty protection or to promote, market, or recommend any information contained herein. Before acting on the information in this Planning Advisory, a competent professional should be consulted.