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Follow tax rules when lending money to heirs
Lending money to family members not only helps them out financially, but it can be a tax-effective way to transfer wealth to the next generation.
Lending rather than giving allows you to provide wealth to the younger generation without totally parting with the money. You can hold on to your retirement nest egg, while encouraging financial responsibility among your heirs.
When you lend money to family members, it is important to charge a rate of interest at least equal to the applicable federal rate (AFR). A lower interest rate can trigger adverse income and gift tax consequences.
The wealth transfer occurs when the younger generation invests the borrowed funds and earns a rate of return greater than the federal rate. When the borrower repays the loan plus interest, the borrower keeps the spread between the investment returns and the interest cost – without gift or estate taxes applying. Lower market rates of interest have kept the AFRs relatively low. So investment returns can outpace the interest rate on the loan.
Federal interest rates are published monthly and vary based on whether the term of the loan is short-term (three years or less), mid-term (more than three years but not more than nine years), or long-term (more than nine years). The AFR also varies depending on how frequently interest is compounded.
For September 2012, the AFR for loans compounded annually are:
Short-term: 0.21 percent
Mid-term: 0.84 percent
Long-term: 2.18 percent
The loan balance itself is an asset in your estate. If you die before the loan is repaid, the borrower must still repay the loan to your estate, unless you structure the loan to have it forgiven if you die before it is paid off.
The downside of an intergenerational loan is the risk that the borrower’s investments will not outperform the AFR. There is also a tax risk that the IRS might challenge the loan as a disguised gift. To avoid this result, you must treat the transaction as a legitimate loan. Document the loan with a promissory note containing enforceable terms. If your heir is unable to make a payment, you should make a genuine effort to collect the funds.
Consider the following example: In September 2012, Grandfather lends $1 million to Granddaughter for three years. Granddaughter signs a promissory note that requires annual payments of interest only at the AFR of 0.21 percent. The loan calls for a balloon payment of principal at the end of the three-year term.
Granddaughter places the borrowed funds in investments that earn a 5 percent return. At the end of the loan term, Granddaughter’s investments will have grown to about $1,151,000, after using the investment income to make $2,100 of annual interest payments. After repaying the $1 million principal, she is left with more than $150,000. Grandfather has essentially transferred that amount to her, free of gift and estate taxes.
The technical information here is necessarily brief. No final conclusion on these topics should be drawn without further review and consultation. Please be advised that, based on current IRS rules and standards, the information contained herein is not intended to be used, nor can it be used, for the avoidance of any tax penalty assessed by the IRS.
© 2012, CPAmerica International. All Rights Reserved.