Intra-family Loans, Part 1

It’s easy to think of examples of situations in which a loan to a family member would be appropriate – helping out during a period of financial distress or assisting the purchase of a home, for example.  It’s a time honored form of assistance that has enabled many to get through a tough time, acquire a new home, or start a new business venture.  In many families it’s easier to go to the Bank of Dad than the Bank of America – and the rates can be better too.

When someone does make a loan to a member of the family, the question of what to charge for interest must be addressed.  It’s important to understand that to qualify as a loan under IRS rules, the money must be repaid and interest must be charged.  If the principal is not repaid, the IRS may consider it to be a gift (if the amount is above the annual and/or lifetime exclusion amounts) and apply the gift tax.  If no interest is charged the IRS may impose penalties as well.

Generally speaking, the lender is making the loan to help someone, not to make a large profit.  The interest charged can be a nominal rate, but it cannot be too low.  The IRS requires that a certain minimum rate be charged or, once again, the question is raised as to whether this is a loan or a disguised gift.  The rate that the IRS requires is called the Applicable Federal Rate (AFR) and is adjusted each month.  The rate is lowest for loans of less than 3 years, higher for 3 to 9 years, and highest for longer than 9 years, but in all cases is lower than what banks would charge for personal loans.  One can charge more than the AFR without IRS concerns, but rates that are lower can attract scrutiny and result in penalties.

When making a loan to a family member, it’s advisable to formalize it in a written document such as a promissory note.  This is recommended for several reasons.  It lays out the details of the transaction, i.e. repayment terms, security (if any), due dates, etc., thereby avoiding misunderstandings at a later time.  It provides documentation of the nature of the transaction for the IRS if they should come knocking.  And, it provides legal documentation of the lender’s rights if the borrower defaults.  A list of issues to consider when making such a loan and drawing up the documentation are contained in an earlier post to this blog.

By the way, everything discussed here would apply equally to a loan to a friend.  The issues relate to structure and form, not to the legal relationship of the parties.