Finding ways to earn more money on your cash has become incredibly frustrating. With money-market accounts offering paltry rates hovering around 0.5%, some of my clients are deciding instead to put their savings to work by lending it to other family members.
Intrafamily loans have long been used in estate planning, but recently, the conversation around them has shifted. More parents I speak with now see intrafamily loans as a way to earn higher returns for themselves, while giving kids or grandkids a lower interest rate than they would receive from a bank.
These loans can help finance any number of purchases, from a new car or house to bigger investments like buying a stake in a business. For any intrafamily loan, though, it’s critical to choose an interest rate that meets both parties’ goals–and to set up the arrangement so it passes tax muster and maintains family harmony.
Choose The Right Interest Rate
For any intrafamily loan, the IRS’s Applicable Federal Rate (AFR), establishes the minimum interest rate you must charge to ensure the funds aren’t considered a gift for tax purposes. The IRS’s AFR table publishes updated minimums according to the length of the loan terms—and as long as you set a rate at or above the AFR for the length of loan in question, you can structure the arrangement however you chose.
Deciding how much interest to charge ultimately depends on your goals and the circumstances of the loan. If you’re offering the loan as a mutually beneficial arrangement that helps a loved one while earning you a bit more than you could get otherwise, then sticking close to the published AFR might make sense. Likewise, if your family member is borrowing money to buy a depreciating asset like a car, the AFR is probably appropriate.
But if there is a big gap 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 purchase an asset that generates a return—like a stake in business or an income property—it can be reasonable to charge something above the AFR.
One approach is to add a portion of the difference—say, one-quarter to one-half of the difference—to the AFR. For example, if your child would pay 5% on a business loan over the next 10 years, but the AFR is 2.82%, you might charge 3.5%.
Important Considerations To Earn More on Your Cash
Even if the potential interest you can earn looks appealing, the following guidelines are critical to structuring a successful intrafamily loan:
- Make sure a bank would finance the borrower. Have your family member go through a loan application process to ensure they would qualify and what rate they’d be offered. This step helps protect your loved one in case you need your money back and they need alternative funding.
- Create legal documentation. Work with a certified public accountant or tax adviser to document the loan terms and ensure you’re filing proper paperwork—such as recording a lien against the property if the loan is used to purchase a home.
- Pay your taxes. The interest you earn is subject to ordinary income taxes. Have an accountant draw up an amortization table so you can report your interest income appropriately. You can use services such as TimeValue or National Family Mortgage to help facilitate interest payments and generate statements of interest for tax and recordkeeping purposes. And remember to include the cost of this software when determining what interest rate to charge to ensure you’re earning a higher return than you’d get in a money market account.
- Weigh the repercussions of default. You shouldn’t tie up a big portion of your net worth in an intrafamily loan. As long as the amount is less than 1% of your overall net worth, there’s probably not a big concern. However, remember that a default could trigger gift taxes, which range from 18% to 40% of the value of the loan.
- Safeguard family relationships. Money can trigger a lot of complicated emotions. Handle discussions around an intrafamily loan with business-like etiquette—in other words, bringing it up at a family dinner is probably not appropriate.
Don’t Overlook The Costs and Risks To Earn More Money On Your Cash
Whether you’re lending money to a child or grandchild, an intrafamily loan is an official lender-borrower agreement—and you should treat it as such.
Carefully consider what you’re entering into and take the time to determine whether lending money to family makes sense from a relational perspective and in terms of wealth planning.
If you want to deeper insight on how to structure a family loan or evaluate if it’s the best way for you to earn more on your cash, I share additional insight on what you need to know before you lend money to your family.
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This post first appeared on Wall Street Journal: Want to Earn More on Your Cash? Try Lending to a Family Member.