It has been described by some as the “Bank of Mom and Pop,” the “Family Bank” by others.
It’s an intra-family loan, and like the 1966 Clint Eastwood Western, it can be a case of The Good, the Bad, and the Ugly.
“It’s a strategy we’ve used for our clients,” said Joseph Marmorato, CPA, and Manager of Tax Planning for Domani Wealth, which has offices in Lancaster, Hanover, York, and Wyomissing.
The strategy is a response to the recent and rapid rise in interest rates, which Marmorato described as having been “historically low.” Difficult economic times have caused the Federal Reserve to increase rates dramatically in recent months to deal with high inflation.
Previously fixed at 3% for a 30-year mortgage, interest rates are spiking to 7.1% at time of writing. The increases affect not only individuals applying for a mortgage, Marmorato noted, but also those seeking business loans, student loans, and personal loans.
As these increases impact every would-be borrower, some family members are turning away from refinancing – as a quarter of American homeowners did a year ago when interest rates were low – and are turning to each other. Thus the “Bank of Mom and Pop” and the “Family Bank” are, in some cases, replacing traditional financial institutions such as banks, credit unions, and mortgage companies.
“Intra-family loans offer benefits over commercial loans and can offer the borrower friendlier terms,” Marmorato said. “You can also avoid lender fees and closing costs.”
Intra-family loans provide capital for investing, paying down high-interest loans, or purchasing power. They can help the borrower through difficult financial times following the loss of a job or covering unforeseen expenses or living costs. They can also assist in buying a home or starting a business.
These personal loans can lock in lower interest rates than a traditional lender. Currently, the rate for an intra-family loan is locked in at 3.4%. At the same time, intra-family loans may not be easy to come by, since the borrower needs to know someone who has the capital to loan.
Intra-family loans work like conventional loans in that there are two parties – a borrower and lender. Money can be lent person-to-person, or through a family business or family trust. As long as the trust has the necessary assets, a person may borrow from it, providing the trust is structured to allow for loans.
The following represent the pros of an intra-family loan:
- Interest rates are lower and locked in
- Borrower may benefit from terms and conditions friendlier than those of a lending institution
- Lack of lending fees.
Such are the Good aspects of an intra-family loan. The Bad can be represented by the following:
- Finding a family member with the needed capital
- If the loan is not properly structured, it can lead to tax consequences
- Borrowing from family also can prevent building a credit history needed to obtain commercial loans or credit cards.
And there’s potential for the Ugly:
- Family relationships can be strained by intra-family loans. An intra-family loan done for one family member and not another can result in jealousy and relational issues
- Loans may differ for each child, based on the child’s financial or personal situation
- Family friction can occur if the borrower is unable to, or chooses not, pay back the loan.
“Intra-family loans,” Marmorato cautioned, “can lead to family problems.”
The benefits of an intra-family loan can be significant, providing both parties adhere to its terms. Proceeding with an intra-family loan means getting professional help from an attorney or wealth advisor to be certain the document is drafted correctly and properly structured. Like a commercial loan, an intra-family loan should be structured to include all conditions and terms, including the length of the loan, the interest rate charged, and repayment schedule.
As is the case with a conventional loan, the borrower must honor the repayment schedule. Any deviation, Marmorato stated, could cause the loan to be disqualified in the view of the Internal Revenue Service (IRS), thus leading to unintended tax consequences.
While intra-family loans can offer terms more friendly than a commercial lender, payment rules exist, otherwise the loan could be considered a gift by the IRS.
“The IRS wants to make sure it is a properly structured loan,” said Marmorato. “You have to make sure it is set up as a loan and not as a gift.”
Like conventional loans, there is a limit to the lowest interest rate that can be charged.
“The Applicable Federal Rate (AFR) is the minimum interest rates that can be charged on a loan,” Marmorato said. For loans exceeding $10,000, the interest rate should not be less than the monthly AFR, which currently stands at 4.3% for long-term loans of nine years or more. Lenders cannot charge below the monthly AFR, less they incur tax consequences.
The appropriate AFR is dependent upon the duration of the loan. Loans are categorized by the IRS according to their length:
- Short-Term – Less than 3 years
- Mid-Term – 3-9 years
- Long-Term – 9 years and more.
Along with the length of the loan, there are tax implications to be considered by both borrower and lender. Marmorato said the lender must recognize the interest income received on their tax return, as the IRS states that even if interest is not paid, imputed interest may need to be reported on the tax return of the lender.
The borrower may be able to deduct the same interest on their tax return. Exceptions exist, and deducting the interest means itemizing deductions along with meeting additional requirements. Additional tax implications exist and can be explained at length by a wealth advisor or attorney.
The structure of the intra-family loan, Marmorato emphasized, is essential to its success.
“It’s critical to contact a tax attorney to draw it up,” he stated, “and have all parties agree to the structure of the loan.”