The Bank of Mom and Dad: A Guide to Intra-Family Loans

/ July 27, 2015

Hands and money in envelope - iStockWe’ve all heard jokes about taking a loan from the Bank of Mom and Dad. What you might not know is that intra-family loans can be a great way to transfer significant wealth and avoid gift (or estate) tax liability. While an intra-family loan requires some upfront structuring and down-the-road diligence, the benefits are real.

This article is a general guide to taking advantage of the wealth transfer possibility of an intra-family loan. Before making any decisions about your specific situation, however, you should consult an attorney.

I. Transfer of Wealth via Intra-Family Loan: An Example

The interest rate one can charge a family member is often less than what that family member might be able to obtain from a commercial lender. Accordingly, it’s possible to transfer wealth by loaning assets to trusts or individuals within your family. Let’s look at a simple example: Mom loans Daughter $1,000,000, with a 9-year balloon note bearing interest at 1.65% compounded annually (selecting an appropriate interest rate will be discussed further below). Let’s assume Daughter realizes a 6% return from growth and income of the money.

Here’s the resulting transfer of wealth:

Amount in Daughter’s account after 9 years: $1,689,479
Amount Daughter owes Mom after 9 years:   $1,158,688
Net wealth transfer to Daughter:                      $530,791

Assuming Mom’s loan to Daughter was structured properly—more on that below—wealth was efficiently transferred to daughter with no gift tax consequences.

II. Avoiding Gift Tax Consequences

The example above illustrates the potential upside to intra-family loans. To avoid gift tax consequences, however, close attention must be paid to ensure the loan is actually treated as a loan by the IRS. To avoid running afoul of the IRS, you should:

  1. Structure the loan. Set the loan term, and select the appropriate interest rate.
  2. Document the loan. The IRS (not to mention you and your children) may want to see proof of the loan’s terms down the road.
  3. Repay the loan. (This one’s for the kids). Forgiving repayment is possible, but may lead to complications.

a. Structuring the Loan

First, you need to determine the length of the loan. A term loan has a set maturity date (e.g. 9 years) and have a fixed interest rate. A demand loan has no set maturity date and a floating interest rate. It’s called a demand loan because the lender has the right to “demand” full repayment at any time. Demand loans may have additional tax consequences as discussed below.

Second, you need to determine an appropriate interest rate. And yes, you must charge interest (if you don’t, the interest will be imputed). An interest free-loan to a family member is considered a gift for tax purposes. The lowest interest rate you can charge a family member is generally the Applicable Federal Rate (“AFR”). Interest on loans should not be less than the AFR for the loan to be considered a taxable event and not a gift by the IRS. Each month, the IRS publishes the AFR. The AFR varies depending on the length of the loan (short, mid, and long-term). They can be found online here.

Interest rates that are lower than the AFR are considered below-market. If the lender charges interest at a below-market rate, the difference between the actual interest charged and the AFR rate is considered “forgone interest.” Forgone interest can create unwanted tax consequences for both the borrower and lender. The IRS will treat the forgone interest as having been received by the lender and retransferred to the borrower as a gift. Further, the lender must pay income taxes on the forgone interest even though the lender never actually received the interest.

Determining the appropriate interest rate for demand loans can be even more complicated. Because a demand note has no fixed maturity date, a demand note must constantly have a rate at or above the mid-term AFR rate, which changes every month. Accordingly, while a demand note may make sense for you and your family, some additional diligence is prudent.

Additional loan structuring techniques may also be practical. For example, you may want to consider having the borrower pledge collateral, or otherwise secure the loan with a lien or mortgage. (Some states, including Minnesota, charge mortgage registration tax, which can be costly).

b. Documenting the Loan

Assuming you’ve done everything right up to this point, the IRS probably won’t want to take you at your word that you’ve properly structured the loan. The IRS essentially asks this: At the time the loan was made, did both borrower and lender intend it to be a loan? Having documentation of the loan can go a long way here.

First, and perhaps most obviously, have the borrower sign a promissory note. Remember, your state may have specific rules about promissory notes. For example, Minnesota allows an individual to write her own note, but you can’t write a note for another person (unless you’re an attorney).

Second, if possible, it may be prudent to document the borrower’s ability to repay the loan. In determining whether a loan is, in fact, a loan, the IRS may look at the borrower’s ability to repay the loan at the time it was made. For example, Mom wants Son to own a home while at college. So, Mom loans Son $200,000 at the AFR rate to buy a home. Son has no income and no other assets at the time the loan is made. The IRS may consider the transfer a gift in the year the loan was made. Further, if the IRS determines the loan was a gift in some later year, Mom could incur penalties.

Finally, the parties should document any pledged collateral or security interests relating to the loan.

c. Repaying the Loan

This one is for the kids (or other borrowing family member). Make payments on the loan! Perhaps the best indication that a loan is, in fact, a loan is that payments are made towards the principal! Although this seems fairly straightforward, clients often want to know: “can I forgive the loan?” The answer, like all good lawyerly answers, is: it depends.

As you may or may not know, each year, individuals can give away up to $14,000 to one or more individuals without the gifts being considered taxable gifts. Married couples can “split” gifts and increase that amount to $28,000. This amount, called an “annual exclusion” can be used as a loan forgiveness technique. Some families, for example, use their annual exclusion gifts to forgive loan repayments. Of course, forgiving the entire loan in this way could cause complications because the IRS could view it as a pre-arranged plan to forgive the loan payments and may treat the loan as a gift. Further, even though you have forgiven the loan payment, you must still pay income tax on the interest. Ultimately, lenders should be cautious about loan forgiveness and should consult with an attorney.

III. Conclusion

Intra-family loans can be an efficient device to transfer wealth within a family. Before doing so, however, the parties should carefully consider how the loan will be structured, documented, and repaid. Consult your attorney to see if an intra-family loan makes sense for you.


The author would like to acknowledge and thank David Joyslin, an attorney with Best & Flanagan, LLP for his assistance with this article and for the inspiration for the topic.

The author [Diana] would also like to acknowledge and thank Evan Nelson, a 3L at the University of North Dakota School of Law for his research and assistance with this article.

2 thoughts on “The Bank of Mom and Dad: A Guide to Intra-Family Loans

  1. I know this article is a couple years old, but I thought it was worth a shot anyways.

    If I was to be loaned money that followed these requirements, is there a way to have a deferred loan? So if my mother gifts me $150k with the required interest, but doesn’t want payments to start for 10 years, is that considered a gift? Or are deferred loans accepted?

    1. Thanks for your question, Leila. We appreciate you reading Epilawg. Unfortunately, we cannot provide specific legal advice on this site. Be sure to contact a legal professional in your area with these questions. Thanks again for reading Epilawg!

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