Seizing the Family Loan Opportunity to Minimize Estate Taxes

The door soon will begin closing for the best opportunity ever to exploit a classic estate planning strategy. The strategy enables many families to transfer significant sums to the next generation while incurring few or no estate or gift taxes. Even estates that won’t be subject to estate taxes can use family loans to achieve financial and estate planning goals.

The family loan opportunity will disappear, because it hinges on today’s low interest rates. Sometime in the next year (perhaps sooner than later) the Federal Reserve will raise short-term interest rates. You’ll still be able to use the family loan strategy, but it will be more expensive.

Here’s how family loans work.

Let’s say a parent lends money to an adult son. The son uses the money to invest, buy a home, pay education expenses, or for any other purpose.

There are no tax consequences to the loan when a minimum interest rate is charged. The interest rate is set by the IRS each month based on market rates for treasury bonds. Recently, the interest rate for loans of three years or less was 0.57%. The rate for loans of three to nine years was 2.45%, and longer term loans needed an interest rate of at least 4.11%. (For small loans of $10,000 or less, no interest needs to be charged.)

When the minimum IRS interest rate is not charged, there could be gift tax consequences. The interest the parent should have charged is considered a gift to the son. In addition, the parent is treated as receiving an interest payment from the son of that amount and must include it in gross income. This is so, though no cash changes hands. When significant loans are involved, the parent may have to file a gift tax return or use part of the lifetime gift tax exemption to report the interest not charged.

As loan payments are due, there are several options.

One option is for the son to repay the loan. Suppose he invested the loan proceeds. He sells the portfolio at the end of the loan term, repays it plus the interest, and keeps any earnings above the interest that was charged. The parent receives the loan proceeds back plus the modest interest that was charged. The excess amount earned by the son now is outside of the parent’s estate without incurring gift or estate taxes. The income and gains above the interest charged also are off the parent’s tax return.

Another option is for the parent to forgive loan payments as they are due. Since only part of the loan is due each year, the forgiven amount may be low enough to qualify for the annual gift tax exclusion ($13,000 in 2010). That would transfer the entire loan plus its earnings out of the parent’s estate tax free. This strategy is a way to help the son buy a home or use the money in some other way that does not generate income.

Loans can be especially helpful to estate owners with businesses or real estate. This property is difficult to give in smaller amounts that qualify for the annual tax exclusion.  The parent who owns the property can lend money to the younger generations to buy larger interests in the business or real estate. The younger generations use income from the business or real estate to make the loan payments. The value of the assets plus future income and appreciation are out of the older generation’s estate. In effect, the older generation’s estate is frozen at the current value plus the modest IRS interest rate.

Now is the time to consider family loans, because interest rates are so low. They are much lower than they were even 18 months ago and probably than they will be in 18 months.

Parents and grandparents who made family loans in the past should consider refinancing them at today’s rates.

There are potential pitfalls to family loans. You need documentation of the loan, proving it really was a loan and not a gift. Also, payments must be made on the loan under terms spelled out in the document. When loan payments are not missed, the lender must enforce the loan. Today, automatic bank payments can be set up to avoid many of the traditional problems with family loans.

There’s always the possibility the assets the younger generation purchases with the loan won’t generate income or will decline in value. In that case, the parent generally takes possession of the assets and loses money on the loan.

The estate tax expired at the end of 2009, but Congress is going to re-enact it. The only questions are when and the terms. You need to keep planning and take advantage of the opportunities that exist. The Federal Reserve will raise interest rates to defend the dollar and prevent a speculative bubble rally in risky assets. The opportunity to make family loans at ultra-low interest rates won’t last much longer.

March 2010. RW