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Giving your adult children a low-cost loan can be a win-win—if you meet IRS rules.


Want a car loan at 2.4% or a 4.6% mortgage? Look to Mom and Dad—not your bank.

Want a car loan at 2.4% or a 4.6% mortgage? Look to Mom and Dad—not your bank.

A below-market-rate loan can not only help your children achieve their financial goals but can also help shift assets from the older to the younger generation with minimal tax effects.

To qualify as a “non-gift loan” under IRS rules, the loan should include the same requirements as those imposed by institutional lenders on borrowers. Such requirements include an adequate interest rate, signed loan documents detailing payback terms, and perhaps collateral.

An “adequate interest rate” must not be lower than the Applicable Federal Rate (AFR) for the month in which the loan is made. Three AFRs are set by the IRS each month. The short-term rate is for loans lasting up to 3 years, the mid-term rate is for loans lasting more than 3years but not more than 9 years, and the long-term rate is for loans lasting more than 9 years.

For loans made during September 2008, the short-, mid-, and long-term AFRs were 2.38%, 3.46%, and 4.58%, respectively. A 3-year loan at 2.38% to buy a new car certainly beats the current bank rate of about 6.5%. And the interest paid stays in the family rather than going to a bank or finance company.

Or perhaps your son or daughter is purchasing a new home, and the mortgage payments are a little rich for your child’s budget. You could lend your child, say, $500,000 to purchase a home with a 15-year repayment schedule, and charge an interest rate as low as 4.6%.

Of course, the parent or parents have to be affluent enough and generous enough to not need the income they’ll forgo.

AFR loans carry some additional requirements. For instance, the borrower must “pay” the interest but can do so via an increase to the loan principal. And the interest is generally taxable to the lender annually whether paid or added to the loan principal.

If interest rates go lower than they are today, you can simply refinance the original loan. If rates go up, the child will get an even greater the benefit from the low fixed rate.

If you simply want to transfer wealth to your child, you could, for example, make a $500,000 loan for nine years at 3.46%. If the child earns 8% and pays 3.46%, his or her pre-tax benefit would be $22,700 annually.

Gift loans and some ways around them

If you give your kids a no-interest loan, it can become what the IRS considers a “gift loan” with some adverse tax consequences, including producing taxable phantom income for the parent.

But there are two exceptions to gift loan rules. One is for loans of $10,000 or less, as long as the funds are not used by the child to purchase or invest in income-producing assets. No income is imputed to the parent and the parent doesn’t have to report a gift to the child.

The second exception covers loans up to $100,000 from parent to child. If the child’s net investment income (generally interest, dividends, and capital gains less investment expenses other than interest) for the year is $1,000 or less, no interest is imputed to the parent and no gift is deemed made to the child. If the child’s net investment income is more than $1,000, the interest imputed to the parent is the amount of net investment income earned by the child.

For parents who want to provide substantial financial support to their children, a below-market-rate loan can be an excellent planning opportunity. But to achieve the maximum advantage for you and your children, it has to be structured right.

Doris Merrick is tax director at Brinton Eaton Wealth Advisors, a financial planning firm in Madison, N.J. She can be reached at merrick@brintoneaton.com

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