Recent events in the financial markets have created a much discussed “credit crunch” in commercial lending institutions. With interest rates from commercial lending institutions still significantly below historic averages, it is natural to be focused on the opportunities of low-cost borrowing. However, it may be difficult in this economic climate to find commercial lending institutions willing to lend money to assist your family with its needs. For example, you may have a child or grandchild looking to purchase a home, fund home improvements, start a business, or provide liquidity for investments or any number of other purposes.

While commercial rates are certainly low, they are not the only rates that are at historical lows. IRS published rates are also at their lowest level in some time, and these low rates present real planning opportunities to allow you to assist your family while, at the same time, shifting wealth between generations with little or no gift tax implications.

Intrafamily loans present one such planning opportunity. Intrafamily loans may be made without gift tax implications as long as the lender charges interest at a rate no less than the “applicable federal rate.” The applicable federal rates are determined and published by the IRS on a monthly basis and are based on the average market yield on outstanding marketable US government obligations of varying lengths.

With proper planning, an intrafamily loan can provide a significant benefit to a junior generation family member with relatively modest tax implications to the senior generation family member. Not only can intrafamily loans be made at rates lower than those commercially available, but the payment terms can be designed to fit the specific needs and resources of the borrower. Balloon notes that require only the payment of interest currently provide an attractive way to provide liquidity for a child or grandchild without the immediate burden of substantial loan payments.


Parent is in the current top federal income tax bracket of 35% and lends $300,000 by means of a thirty-year promissory note to Child and Child’s Spouse so they can purchase a new home. The promissory note is secured by a mortgage so that the Child can deduct the interest payments. The interest rate is at the 4.45% December 2008 long-term applicable federal rate and is payable on December 31 each year, interest only, with the principal due only at the end of the thirty-year term. Parent decides on a year-by-year basis whether to forgive or collect the interest, depending on Parent’s own cash needs.

If Parent forgives the interest at the end of the first full year of the loan, he or she will be forgiving a total of $13,350 in interest, which is less than the $24,000 combined total in annual exclusions gifts in 2008 Parent can make to Child and Child’s Spouse. The tax rules still require Parent to report the forgiven interest for income tax purposes, and the forgiveness results in an out-of-pocket cost to Parent of $4,672 ($13,350 x 35% marginal tax rate). Because the tax rules treat the loan recipients as actually having paid the interest to Parent, they are entitled to an income tax deduction in the amount of $13,350, which saves them $4,672 in income taxes, assuming that they also are in the top income tax bracket. From the perspective of viewing the family as a single economic unit, the transfer is a wash and Parent has in effect shifted the tax benefit on a dollar for dollar basis to Child and Child’s Spouse.

As the example in the box above illustrates, it is possible once the loan is in place for the senior generation lender to forgive interest and/or principal from time to time (mindful of the $12,000 annual exclusion limit available in 2008 and the $13,000 annual exclusion limit available in 2009) if the lender wishes to avoid making a taxable gift. Of course, intrafamily loan arrangements should not be created with the implied or expressed understanding that the loan will be forgiven over time; otherwise, there is the risk that the IRS will treat the entire loaned amount as a gift upon inception, which can have unintended gift and estate tax consequences. In addition, special rules apply to intrafamily loans that exceed $10,000 but are less than $100,000, and should be reviewed carefully.

It is important to emphasize that loans from a senior generation family member to a junior generation family member may be made for any number of purposes. Specifically, it may be attractive to loan money to a junior generation family member to afford that family member with liquidity to make investments. To the extent those investments generate a return in excess of the applicable federal rate of interest due on the loan, the senior generation family member has enabled the children to pocket that excess, gift tax-free.