Family loans have long been used in estate planning, but recently the conversation around them has changed. More and more parents I speak with now see intra-family loans as a way to earn higher returns for themselves, while still offering children or grandchildren a lower interest rate than they are. would receive from a bank.

These loans can help finance a number of purchases, from a new car or home to larger investments such as buying a stake in a business. For any intra-family loan, however, it is essential to choose an interest rate that meets the goals of both parties and to put the deal in place in such a way that it passes taxes and maintains family harmony. .

For any intra-family loan, the IRS Applicable Federal Rate (AFR) sets the minimum interest rate you must charge to ensure the funds are not considered a gift for tax purposes. The IRS AFR table publishes updated minimums based on the length of the loan terms and as long as you set a rate equal to or greater than the AFR for the term of the loan in question, you can structure the agreement. as you see fit.

Deciding how much interest to charge ultimately depends on your goals and the circumstances of the loan. If you are offering the loan as a mutually beneficial arrangement that helps a loved one while earning you a little more than you might otherwise get, it may be a good idea to stick with the published AFR. Likewise, if a family member is borrowing money to buy a depreciated asset like a car, AFR is probably appropriate.

But if there is a big difference between the AFR and the rate your family member could get on the open market, or if the money will allow your loved one to buy an asset that generates a return, such as a stake in a business or income property – it may be reasonable to charge something above the AFR.

One approach is to add some of the difference — say, a quarter to a half of the difference — to the AFR. For example, if your child pays 5% on a business loan over the next 10 years, but the AFR is 2.82%, you might charge 3.5%.

Even if the potential interest you can earn looks attractive, the following guidelines are essential for structuring a successful home loan:

Make sure a bank would finance the borrower. Have a family member go through a loan application process to make sure they would qualify and what rate they would be offered. This step helps protect your loved one in case you need your money and they need alternative funding.

Create legal documents. Work with a chartered accountant or tax advisor to document the loan terms and make sure you complete the proper paperwork, such as registering a lien on the property if the loan is being used to purchase a home.

Pay your taxes. Interest you earn is subject to ordinary income tax. Have an accountant prepare an amortization schedule so that you can report your interest income appropriately. You can use services like TimeValue or National Family Mortgage to facilitate interest payments and generate interest statements for tax and record keeping purposes. And don’t forget to include the cost of this software when determining the interest rate to charge to ensure you get a higher return than you would get on a money market account.

Weigh the repercussions of the default. You shouldn’t be locking up a lot of your equity in an intra-family loan. As long as the amount is less than 1% of your overall net worth, it’s probably not a big deal. However, keep in mind that a default could trigger gift taxes, which range from 18% to 40% of the loan value.

Protect family relationships. Money can trigger a lot of complicated emotions. Treat discussions around an intra-family loan with a professional etiquette, in other words, talking about it at a family dinner is probably not appropriate.

Write to M. Lazaroff [email protected]