Power Of Intrafamily Loans: Tools, Legal Aspects, And Cautions

My youngest daughter has been watching the real estate market here in the valley for the past several years and is at a point where she wants to take the leap.  As we all know the availability and affordability of entry level real estate is pretty much a pipe dream for many who fall between the “affordable” housing dictates of governmental (APSCHA)  or non-profit (Habitat for Humanity) avenues and the income/asset requirements to qualify for free market housing.  To help her build on her financial wins of working hard, saving well, and thinking creatively, we are putting together an Intrafamily loan. For assistance with any major expense, this type of loan can be a beneficial “hand up” in building a healthy financial life and I want to share some ideas.

Lower Interest Rates really help. Instead of going through traditional lenders (In part or whole), family members can negotiate terms that are favorable to both parties.  It is important to follow the IRS rules around the Applicable Federal Rate ruling to be considered a loan and not a gift.  If the loan interest rate is below the AFR, the difference between the AFR and the actual rate can be considered a gift for tax purposes. It’s crucial to be aware of the annual gift tax exclusion limits and plan accordingly.

 Intrafamily loans offer flexibility in structuring the loan terms. Families can tailor agreements to meet their specific needs, which may include interest-only payments, balloon payments, or extended repayment schedules.  To ensure that the loan agreement is financially viable for both parties, consider using a loan amortization calculator. This tool helps calculate monthly payments and interest over the life of the loan.

It’s not personal, it’s business!  Create the Promissory Note with legal representation: A promissory note is a written agreement outlining the terms of the loan, including the specific loan amount, interest rate, repayment schedule, and any collateral provided.  What happens if the borrower defaults on their obligations?  Will there be a grace period? How will the penalty be assessed? Will there be costs added to the loan, or will you take legal action?  Can you transfer the loan to another party?  What happens if you pass away before the loan is paid off?  Make sure you discuss the implications with your estate planning attorney. This document formalizes the transaction and helps avoid misunderstandings.

Document, document and document: This is crucial to distinguish an intrafamily loan from a gift. Without formal agreements and regular payments, the IRS may consider the transfer as a gift, potentially subject to gift tax.  You will need to work with your accountant to make sure you create the appropriate tax documentation.  The IRS form 1098 will list how much interest the borrower paid during the year, and form 1099 will show how much interest you received which will be stated on your tax return.  If the proper documentation is not followed, there may be tax consequences and you would not be entitled to a tax deduction as “bad debt” if things go wrong.

Questions you want to ask yourself and discuss with spouse:

  • Can you afford to invest in the borrower?
  • What “skin in the game” does the borrower have?
  • What have been the past interactions with family borrower, and have they been responsible with money in other aspects of their life?
  • Are you willing to enforce terms of the loan?
  • How will a default on the loan impact your relationship?

I have heard stories of family loans gone very wrong.  Lending money to family or friends can put more than your money at risk.  It impacts relationships and best intentions can lead to disaster.  Consulting with professionals, such as attorneys, financial advisors and tax experts, can help you navigate the complexities and ensure a successful intrafamily lending arrangement that benefits everyone involved.  A smart plan is a sturdy plan that is foundation for financial and relational success.


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