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How does loaning money to a child work, exactly? © Shutterstock
May 30, 2017

How does loaning money to a child work, exactly?

That so many people live longer today is a happy fact. But for heirs, there’s also a bit of a downside: delayed inheritances!

For parents with adult children, the dilemma becomes one of choosing how to transfer wealth: Do nothing? Make a gift? Or, make a loan? Although many parents choose to do nothing, benefits can flow from action. With interest rates still hovering at historically low levels (despite some recent hikes by the Fed), now is the perfect time to make a family loan.

For parents who do not want to set up a trust or other expensive tax structure in uncertain tax times, and who, quite frankly, like the idea of getting the money back, the option of loaning money is ideal. The regular payments generated will continually enforce the child’s sense of responsibility and also allow the child to buy a home or otherwise accumulate wealth.

A loan also allows the parent to keep the gift option open by later forgiving principal (through the use of the parent’s $14,000 annual exclusion, or even the $5,490,000 federal lifetime gift tax exemption). So, how does it all work?

THE PROMISSORY NOTE

Yes, these are your kids, but when cash changes hands between parents and children, there should be no confusion about the nature of the transaction: So, use a formal written promissory note signed by the child and be sure to fill in all the blanks: date, principal amount, borrower (debtor) and lender (beneficiary) as well as, what’s most important, the terms.

The note’s terms for repayment trigger the tax consequences and offer an opportunity for the parents and child to discuss intent and expectations.

THE NOTE TERMS

The IRS classifies notes as short-term (less than three years), mid-term (three years to less than nine years) and long-term (nine years or more). Each month, the IRS publishes allowable (Section 7872) rates in the Applicable Federal Rate table. Applying numbers to the table rates by example helps.

For example, using April 2017 rates, a parent could loan a child $100,000 at 1.11 percent interest, or $1,110 payable within three years (or $11,100 on a $1 million loan). If the April 2017 loan is a mid-term loan, the rates fluctuate slightly, depending on the frequency of required interest payments (2.12 percent percent annually or 2.10 percent quarterly), so the child makes annual interest payments of $2,120 on a $100,000 loan (or $21,200 on a $1 million loan).

LIFE WITH THE NOTE

Even though the IRS is willing to allow interest on intrafamily loans to be far below commercial rates, debts to children should be treated like third-party obligations. Parents should keep records showing timely interest payments and declare the interest income for tax purposes.

Any method of showing that the loan principal is likely to be repaid, such as securing the loan against the child’s property, is even better. If structure is disregarded, the IRS might characterize the transaction as a disguised gift.

Given current rates, however, there is really no excuse for a child to miss a payment. In fact, you might consider making interest payments due on your birthday. Just a reminder that everyone wins with a delayed inheritance.


This article was originally published in the May–July 2017 issue of Worth.

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