What to know about intrafamily loans

Similar to forming a business with a friend, loaning money to a relative may seem like a good idea at the time. To help avoid some of the potential pitfalls–and in an attempt to take advantage of some of the possible benefits–it’s a good idea to prepare accordingly.

Lending between family members is a very common occurrence. Virtually every family has a story about a helpful relative who used some form of a loan to help with a down payment on a house, front educational expenses, or help purchase a car. What many people may not realize is that there are tax consequences to these actions, which can be a trap for the unwary. With thoughtful planning, and some guidance from experienced tax and legal advisors, you can provide some transformational financial assistance to members of your family without triggering unexpected tax effects.

What is an intrafamily loan?

An intrafamily loan is very simply defined as a loan from one family member to another. The real question for many is whether the IRS will formally recognize the transaction as a loaner-debtor relationship for tax filing purposes. Why does this matter? When structured properly, intrafamily loans can be a great wealth transfer tool as they don’t count toward your tax-exempt gift amount. For example, in 2024, many non-charitable gifts more than $18,000 in value must be reported to the IRS. Instead of making an outright gift, you may want to consider triggering a loan instead.

Intrafamily loans are attractive because they allow the parties to create flexible repayment terms and interest rates that are often lower than current commercial loans. The loans can be structured to include interest-only payments or fully amortized. If interest rates fall in the future, the family members can renegotiate terms, much in the same way that a mortgage can be refinanced. Finally, it can be an opportunity for family members to have access to a loan that likely would not otherwise be available to them while opening the doors to conversations on financial responsibilities and literacy.

Setting it up

In order for the loan to not be characterized a gift, it’s important that you work with your tax and legal advisors to ensure that the transaction meets important criteria. Some requirements to consider include:

• Establishing the Interest Rate: Intrafamily loans should abide by the Applicable Federal Rate (AFR), at a minimum. The AFR is re-set every month based on current economic conditions and listed on the IRS website. Using this base interest rate, the interest rate for the specific loan is then set using factors such as loan duration. This mandatory rate is usually much lower than other conventional interest rates offered in the market.
• Establishing a formal creditor-debtor relationship: The more formal the relationship, the more likely it is that the IRS will recognize it as a legitimate loan, but there may be issues to prepare for. ls there written, signed documentation? Does the borrower actually make payments? Are there consequences if the payments are not made? Does the borrower have any credit to support the loan? *Note that if the interest is not paid bock by the borrower, then the loan has a much higher risk of being considered a gift by the IRS as part of your taxable estate, thus subjecting you to potential unplanned tax penalties.

Special considerations

Families are always looking for ways to gift money without using their lifetime gift exemption. A potential wealth transfer strategy without using this exemption would be through a loan to a family member to use toward investments at a lower interest rate than the rate of return on the investment. Family members can even write in clauses such as a “self-cancelling installment note” which allows for the loan to be forgiven at a future date without having the remaining unpaid balance as part of your taxable estate .

It's wise not to disguise a gift as a loan because if the lender ends up forgiving the loan, any unpaid amount could be considered as a taxable gift. And in that case, the borrower may owe taxes on the remaining unpaid interest. You could consider forgiving a certain amount each year to avoid gift tax. Because the rules are complex if the loan is considered a private mortgage, it's best to discuss this with a tax or financial before finalizing the details.

High-net-worth individuals

Intrafamily loans are an excellent option for transferring wealth to heirs while mitigating wealth transfer taxes. By lending money to family members at below market interest rates, you benefit from rate arbitrage, an efficient way to enhance family wealth.

Intrafamily loans can also be put in trust but there are a few more nuances to this method, so it’s important to consult with legal and tax representatives. Consideration should also be given to the family dynamic aspect of such loans. In the event a loan is given to one person and not others or similar type scenarios, there could be potential dissension among family members.

Getting the advice you may need

Intrafamily loans can bring up many potential considerations when family and finances are involved. Tax law and its direct impact on you when considering this type of loan is also worth the time and conversation. To learn more, please contact your Huntington Private Bank team to see how we can help, or find a Huntington Private Bank Office near you.