Consider looking close to home when seeking a loan

Bill Cass, CFP®, CPWA®

Bill Cass, CFP®, CPWA®, 09/19/23

The recent surge in interest rates is hitting homebuyers especially hard as 30-year mortgage rates surpass 7% for the first time in more than two decades.

For some families, there may be an alternative to securing a mortgage from a financial institution at today’s prevailing rates.

If structured properly, an intrafamily loan may be a way for family members to help others purchase a home and avoid triggering a taxable gift. Overall, while there are many important considerations, an intrafamily loan can be a powerful way to help other family members build wealth and security.

How does an intrafamily loan work?

To avoid being considered a taxable gift, a loan between family members has to be structured and executed properly. Like any other loan, it must be formally documented. A promissory note is drafted and must charge interest based on prevailing market rates and the term of the loan. The family member lending the funds must apply an interest rate consistent with monthly interest rates published by the IRS (Applicable Federal Rate, or AFR). The IRS publishes three different rates based on the term of the loan — short term (zero to 3-year repayment), mid term (3 to 9 years), and long term (more than 9 years). The lender can charge a higher interest rate than the current AFR, but the IRS may consider the loan to be a gift if the interest rate is lower. Lastly, the loan agreement may include other details such as frequency of payments, level term payment schedule or adjusting rate, or other features such as a balloon payment.

Intrafamily loan as an alternative to current mortgages

While the current high-interest-rate environment is generally not favorable for certain financial planning strategies including intrafamily loans, given the sharp increase in mortgage rates, an intrafamily loan may be a viable alternative to traditional bank financing. In fact, the current spread between 30-year mortgage rates and the long-term AFR is roughly 3%.

Intrafamily loan and current mortgage rates, 2018–current

family loan versus traditional mortgage

Sources: IRS, St. Louis Federal Reserve.

In addition to the difference in interest rates, here are some other reasons why an intrafamily loan may be preferable to a traditional mortgage:

  • Avoids transaction and servicing fees assessed by a mortgage provider
  • Provides the family member borrower with access to credit without going through the underwriting process
  • Could supply the family member lender income at a rate comparable to what they might receive from another fixed income investment option.

Lastly, similar to a traditional mortgage, a family member can deduct interest payments on an intrafamily loan on their federal tax return if itemizing deductions.

What could go wrong?

Families should pursue this alternative with a clear understanding of the potential drawbacks and establish clear communication among participants to set expectations. For example, if the repayment agreement is not followed, the family member lender must consider the risk of the loan eventually becoming a gift that could trigger federal gift and income taxes (and result in loss of wealth to the lender). There are also opportunity cost considerations. The funds being used as part of the intrafamily loan could have been designated for other purposes. Lastly, there may be other concerns if the same loan offer is not presented to other family members who may be resentful.

Formal documentation is critical in the event of an IRS audit or a dispute amongst parties. Those interested in pursuing an intrafamily loan should consult with a qualified legal and tax professional knowledgeable of the potential tax ramifications.