With mortgage rates near the highest levels in recent memory, many families are searching for alternative financing arrangements to help younger members get on (or climb) the real estate ladder. One potential solution that has been utilized successfully for decades is an intrafamily loan.

How do intrafamily loans work?

In short, an intrafamily loan replaces a traditional lender with a family member. Typically, we see a matriarch or patriarch loan money from one generation to the next. While this is commonly done for a real estate purchase, it can also be for other reasons, such as starting a new business. Proper intrafamily notes are structured much like a traditional lending arrangement, with formal agreements around items such as:

• Amount: How much is being loaned?
• Term: What is the length of the note?
• Payments: How are payments made? Are payments interest-only or principal and interest?
• Interest Rate: What is the applicable rate?

To reduce gift tax concerns, the interest rate should be at least the Applicable Federal Rate (AFR). The AFR is published monthly and provides the minimum interest rate the IRS deems appropriate for the term of the loan to reduce gift tax concerns. As payments are made, the lender reports taxable interest income. Families should work with legal counsel to draft the promissory note outlining the terms of the arrangement. If drafted and recorded properly, an intrafamily mortgage loan may allow the borrower to deduct their interest costs, as is common with a typical mortgage loan. It is important to also work closely with a tax advisor.

Advantages of Intrafamily Loans

The primary advantage of this tool is to lower the interest rate for family members in need of funds. These savings can be significant over the life of the loan. In the example shown in the chart, a borrower with an intrafamily loan at the current AFR would save $25,000 over the first 10 years. 

Savings for Intrafamily Borrowers

Table is for illustrative purposes only. Data sources: Standard fixed interest rate for Minnesota, July 2024. Applicable Federal Rates for July 2024. Amortization calculator.  

Table is for illustrative purposes only. Data source: Amortization calculator.

These types of loans can also aid in estate planning and family gifting. Some families could consider utilizing annual exclusion gifts (up to $18,000 in 2024) to reduce the principal balance owed to the borrower by the lender. Annual exclusion gifts are the amount that one individual can give to another individual without income and gift tax consequences.

Intrafamily Loans are Not Without Risk

While making an intrafamily loan is a generous way to smooth the path for a family member, there are important considerations to take into account. Legal concerns can arise if the IRS reviews the terms of the loan and deems it as a gift. For this reason, it is important to work with legal counsel to draft the note.

The borrowers should be credit-worthy and have the means to repay the loan, just as would be required for a conventional mortgage. Additionally, the risk of the IRS deeming the loan a gift is reduced by collecting payments on the note and reporting the interest income on the lender’s income tax return. In short, treat the loan as a loan.

The lending family member should keep in mind how they will fund the loan. There may be tax implications associated with creating the funds to make the loan. Additionally, there will be ongoing tax costs related to the interest income.

Family Communication is Key

One additional consideration is family dynamics. These types of arrangements may create strife between family members. It’s important for the parties involved to discuss if, when, and how the details of a loan arrangement are disclosed among the family. Families should also consider what the ramifications and impact may be if the borrower is unable or unwilling to repay the loan.

With careful planning, an intrafamily loan can be a powerful tool to leverage resources for the benefit of the entire family. If this may be of interest to you, your CCM team is here to help you think through the nuances and create an optimal plan.