What feds should know about lending their family members money.
By: Katelyn Murray, CFP®, ChFEBC®, FBS®, CFT-1™, ECA
In our day-to-day work helping Feds create financial plans to meet their dynamic goals, one of the trends we’re seeing more and more of is the concept of “helping” adult children through an intrafamily loan. Given the era of climbing interest rates in which we currently find ourselves, it makes sense that we’re seeing parents who remember the days of double-digit home mortgages become interested in helping their children by providing low-cost loans within the family. Intrafamily loans can be a great option for Feds who are looking to provide financial support to their loved ones. Whether it’s helping your child purchase a new car or helping your siblings consolidate their debt, intrafamily loans allow you to lend money to your family members while also earning some interest along the way. However, it’s important to approach these loans with caution and to follow best practices in order to avoid any potential tax issues.
The first step in creating an intrafamily loan is to draw up a written loan agreement. This agreement should include important details such as the loan amount, interest rate, and payment terms. It should also specify whether the loan is secured or unsecured, and if it is secured, what collateral is being used to secure the loan. A written loan agreement is important for both the lender and borrower as it helps to clarify expectations and reduce the risk of misunderstandings. To help you get started, here is a link to a very simple template resource you can use to put together the loan document—just be sure to change the state of residence in the initial drop-down box to the state in which you reside.
One of the most important aspects of an intrafamily loan is the interest rate being charged. It’s crucial to charge a rate that is “reasonable” in the eyes of the IRS in order to prevent the loan from being considered a gift for tax purposes. The IRS does not provide a specific definition of what constitutes a “reasonable” interest rate, but it’s generally understood to mean a rate that is rational and justifiable. The safest option is typically to consult the Applicable Federal Rates (AFRs) table on the IRS website and use the latest interest rate for long term loans as the interest rate on the loan. Currently, the rate for interest that compounds annually on a long term loan is 4%.
It’s worth noting that the interest being charged on the loan is in some cases optional. Married couples can forgive up to $34,000 of the outstanding loan balance using their annual gifting exclusions of $17,000 per person each year. This means that they could effectively provide a family member with an interest-free loan and only have them pay back the principal amount owed on the loan. To do this, you would use your gifting exclusions each year to “forgive” whatever amount of interest is being charged on the loan. This can be a great option for families who want to provide financial support to their loved ones without charging them interest.
If one does decide to forgive interest, it’s crucial to keep a written log of the interest forgiven each year in case the IRS ever comes asking. This log can be as simple as an Excel spreadsheet where you provide the principal amount of the loan, the interest rate charged, the amount of computed interest, and the amount forgiven annually. By keeping a written record of the interest forgiven which you can easily provide if prompted by the IRS, you can head off any potential tax issues at the pass.
Intrafamily loans can be a great option for federal government employees looking to provide financial support to their loved ones. By following best practices such as creating a written loan agreement, charging a “reasonable” interest rate, and keeping a written log of interest forgiven, you can ensure that the loan remains a loan rather than a gift for tax purposes. As always, though, it’s important to consult with a financial professional to determine if an intrafamily loan is the right option for you and your family.
**Written by Katelyn Murray, Financial Advisor, ChFEBC℠ The information has been obtained from sources considered reliable but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of Katelyn Murray and not necessarily those of RJFS or Raymond James. Links are being provided for information purposes only. Expressions of opinion are as of this date and are subject to change without notice. Raymond James is not affiliated with and does not endorse, authorize, or sponsor any of the listed websites or their respective sponsors.