When your child comes to you, hat in hand, asking for a bit of money...REJOICE! Lend away! And charge interest...you'll make money, the government won't hit you with taxes, and the inheritance can be put to work for them immediately.
Banks are being criticized both for insufficient lending and for making too much profit. While some of these claims are dubious, there is one bank offering ultra-low rates with potentially high lending capacity: The Bank of Mom and Dad.
Fork it over.
Loaning money to children, both adult and younger, is a valuable way to increase family wealth, provide opportunity and avoid burdensome gift and estate taxes. With interest rates low and asset values depressed, now is the perfect time to consider a low-interest family loan.
Estate, Gift Tax Implications
Based on current legislation, 2010 will not have an estate tax. However, in 2011, the exemption level will revert back to its 2001 level of $1 million. Also, Congress could still reinstate the tax at some point before next year and could even make the tax retroactive to January 1, 2010. So, even though the estate tax is gone for now, you should not count on it staying that way.
The amount that you can pass on tax-free before your death is also limited. Each year, any individual taxpayer can give only a limited amount to any other individual without having to report the gift. For 2010 the cap is $13,000.
Gifts beyond that amount count toward a lifetime limit on tax-free gifts, set at $1 million. Gifts above the $1 million lifetime exemption are subject to the gift tax. In 2010 the top gift tax rate is 35 percent.
Family loans can offer a way to reduce or avoid gift and estate taxes. The way that it works is that a parent makes a loan to a child, which the child can then invest, seeking to earn more than the annual interest he or she pays on the loan. If the parent had not made the loan, those gains would belong to the parent and could potentially be subject to estate or gift tax. Instead, using the loan strategy, the excess rate of return goes directly to the child or a trust for the child’s benefit without any gift taxes.
The Internal Revenue Service sets a minimum interest rate that individuals must charge others for a loan not to be categorized as a gift. This rate, known as the Applicable Federal Rate, changes monthly based on prevailing market interest rates. Most financial institutions charge much more than this, but the Bank of Mom and Dad can charge just the minimum.
Since the rate is currently low and asset values are now depressed, a child who receives a loan from his parent at the minimum rate should have little difficulty investing the money at a net profit. The child might use the borrowed money to buy investment securities, to purchase a personal residence or investment property, or to buy all or part of a family business.
One strategy is for the child to use the borrowed money to invest in a diversified portfolio of investment securities, which, though volatile, generally have a high expected rate of return over a long period of time. The Applicable Federal Rate in April 2010 for a nine-year loan is 2.70 percent, so all earnings in excess of that annual rate would be transferred to the junior generation free of gift or estate taxes.
Yet another plan for transferring wealth and/or helping family members is providing a mortgage. Since residential real estate values are currently low but likely to rebound over the next several years, buying a personal residence with a low-interest family loan makes good financial sense.
If the Bank of Mom and Dad is open for business, then it can lend to Junior at low interest rates using the home as collateral. In fact, Junior can borrow 100 percent of the acquisition price without any need for mortgage insurance.
Despite this, we encourage families to consult an attorney to draw up a formal mortgage and promissory note. Adequate homeowner’s insurance should be obtained, just as a bank would require. If Mom and Dad lent for 30 years, the minimum fixed rate for a transaction completed in April 2010 is 4.40 percent.
Taking over the Family Business
Family loans can also be used for business succession. Suppose that Ray owns a restaurant that he intends to pass on to his son, Ray Junior. To avoid gift and estate tax, Ray Senior sells the land and buildings to his son, while at the same time granting him a loan to fund the entire purchase. Ray Junior signs a promissory note — for instance, a nine-year interest-only note at 2.70 percent.
As the landlord, Junior now charges the restaurant rent, which Senior can deduct as a business expense. After paying the annual interest on the loan, Junior can use the excess rental income to pay down the debt. When the nine-year period ends, Junior can repay the remaining balance on the loan or refinance it with Senior or another lender.
When Rates are Low, Lend the Dough
Family loans are most effective when interest rates are low and expected appreciation on investments is high. This leaves a large spread between what the child is required to pay in interest and what he or she can earn with the borrowed money, maximizing the amount that is transferred from the older generation to the younger generation.
Family loans can also provide children with opportunities not otherwise available like purchasing a home, investing in a securities portfolio, or acquiring a stake in a family business.
Since interest rates are low now and asset values are depressed, giving them plenty of room to recover, family loans are a particularly effective strategy at the moment.
Jonathan M. Bergman is Vice President and Chief Investment Officer of Palisades Hudson Financial Group LLC in Scarsdale, N.Y. Since 1992, Palisades Hudson Financial Group LLC has provided a broad range of independent and objective tax, estate, investment, and other financial planning services to professionals, senior executives at major corporations, and high-net-worth families. Its fee-based asset management affiliate oversees more than $950 million in client assets. Palisades Hudson is solely compensated by its clients, ensuring clients’ interests are valued above all. Palisades Hudson serves clients nationwide from offices in Scarsdale, Atlanta, and Ft. Lauderdale.