Take-Away: In order to avoid an implied taxable gift, an intra-family loan must use the applicable federal rate (AFR) of interest when the loan is made. The current AFR rates are historically low. AFR interest rates are going even lower next month. A low interest rate loan enables the lender to shift wealth to the borrower, who presumably invests the loan proceeds and earns a return on the invested loan proceeds, which is larger than the AFR rate that is charged on the borrowed funds, i.e. arbitrage.

July AFR Rates: The July AFR rate is compared to the June AFR rate below:

Short-term loan (0 to 3 years in duration): June 2.37% v. July 2.13%

Mid-term loan (3 to 9 years in duration): June 2.38% v. July 2.08%

Long-term loan (over 9 years in duration): June 2.76% v. July 2.50%

Example: In July, after the AFR drops .30% from June’s AFR, Dad loans Son $100,000 for 8 years and 11 months, i.e. a mid-term loan. Dad charges Son 2.08% on that $100,000 loan. That means that the following July, and each July thereafter, for roughly 9 years, Son owes Dad $2,080 in interest on that $100,000 loan. Over that almost 9 years, Son pays Dad, in the aggregate, $18,720 in interest payments. If Son conservatively invests the $100,000 and earns a 4% annual return on his investment, Son will earn pre-tax $4,000 a year; over 9 years Son will earn $36,000 on his conservative investments. Son repays Dad after 9 years and nets $17,280 pre-tax from his investments over the 9-year period. If son is in a lower income tax bracket than Dad, even more savings are achieved by the family. If Son earned 10% annually on his invested $100,000, the shift in wealth from Dad to Son over the 9 years would be $71,280.

Candidates for Intra-Family Loan Planning: Intra-family loans can shift wealth for those individuals who have already ‘maxed’ out their federal gift tax exemptions. They are much easier to document and monitor than a grantor retained annuity trust (GRAT) which can also be used to shift wealth gift-tax free. Intra-family loans are also useful for those individuals who are afraid to permanently part with their wealth through lifetime taxable gifts- in short, those individuals who are afraid that they might outlive their money. In effect, an intra-family loan is a soft-freeze of a parent’s taxable estate [the loaned wealth increases, but only at the
AFR rate which might be far lower than prevailing market rates], which will hopefully minimize the parent’s estate’s exposure to federal estate taxation.

Conclusion: An intra-family loan is an excellent tool to shift wealth without paying any gift tax. All that is required is a simple Promissory Note signed by the borrower and in cases where larger sums are loaned, probably some form of collateral security, such as a Stock Pledge, Second Home Mortgage, or priority Security Interest, to assure the timely repayment of the loan to the lender.