In the current economic environment, IRS-prescribed monthly interest rates for certain intra-family transactions are at historic lows. As a result, an excellent opportunity exists to transfer wealth to lower generation family members while minimizing taxes through the use of “Intra-Family Loans.”

One simple technique that is particularly effective in the current low-interest-rate environment is to loan money to a child, grandchild, or other family member – or perhaps to a trust for the benefit of one or more family members – with the borrower paying interest on the loan at the appropriate interest rate (referred to as “Applicable Federal Rates” or “AFRs”). The transaction must be properly documented with a promissory note, and interest should be paid on the loan.

The following table shows “safe harbor” AFRs for loans between family members made during July 2016, depending on the term or duration of the loan:

Loan Type

Loan Terms

AFR

Short-term AFR

Up to 3 years

0.71%

Mid-term AFR

More than 3 years and 9 years or less

1.43%

Long-term AFR

More than 9 years

2.18%

The borrower can use the borrowed funds to make investments with the goal of realizing a rate of return in excess of the interest rate payable on the loan. The borrower will eventually repay the loan principal and will keep any investment returns in excess of the interest paid without the excess being subject to estate or gift taxes. This transaction is obviously most effective when AFRs are lower, since the investment return does not have to be as high to exceed the AFR, meaning there is a greater potential for a tax-free transfer to the borrower. AFRs can also be used for loans related to the purchase of a personal residence by a family member or investment in a business.

As an illustration, assume a $1 million loan is made during July 2016, with a term of eight years and interest payable at the “mid-term” AFR of 1.43 percent, and further, that the investment return over the period is 7 percent on an annual basis. Under these facts, the amount the borrower will have remaining after repaying the loan principal, plus interest, at the end of the eight-year term will be in excess of $500,000.

As an alternative, the borrowed funds could be used by the borrower to pay off existing higher-rate debt, the result of which would afford the borrower the opportunity to satisfy the debt sooner than may have otherwise been permitted. In addition, if the existing debt is owed to a bank or other third-party lender, the act of refinancing with an intra-family loan ensures that the interest payable over the life of the loan will remain within the family.