An intra-family loan is a basic estate-planning technique which has a very low transaction cost. Under rules set forth in the Internal Revenue Code, it is possible to make loans to family members at lower rates than those charged by commercial lenders without it being deemed a gift. As discussed below, the lender, usually a parent or grandparent, must charge interest in order to avoid making a gift to the borrower but this interest rate may be as low as 1.63% for a loan for a term of three to nine years, with interest paid annually, made in September 2011. The lender also can structure the loan as a balloon note meaning that the borrower pays interest only during the course of the loan and only repays the principal at the end of the term.

Economic Benefits of Intra-family Loans

If a parent makes an interest-free loan to a child or grandchild, the Internal Revenue Service will treat the foregone interest as a taxable gift. In order to prevent the IRS from treating a part of the loan itself as a gift, the parent must charge a certain minimum interest, which is known as the applicable federal rate ("AFR"), which the Treasury determines every month. To the extent that the interest charged on the loan is lower than the interest calculated with the AFR, that amount will be imputed as income to the parent, even though the parent does not actually collect it. Furthermore, the IRS will treat that amount as a gift to the child, which would require the filing of a gift tax return. However, if a parent establishes a bona fide creditor-debtor relationship with adequate stated interest, the intra-family loan will not be characterized as a transfer subject to the gift tax.

Intra-family loans create an opportunity to shift wealth from one family member to another family member, usually a child or grandchild, if that child or grandchild can earn a greater return on the amount borrowed than the AFR. The minimum interest rate required to be used depends on the period of time of the loan, and the current AFRs are very low. In September 2011, if interest is paid annually on a loan, the AFR for short-term loans (loans for up to three years) is 0.26%. The AFR for mid-term loans (loans from three to nine years) is 1.63%, and the long-term AFR rate for loans over nine years is 3.57%. The AFR for demand loans is the AFR for short-term loans in effect for the period for which the foregone interest is being determined (i.e., monthly), compounded semiannually. To the extent that a child or grandchild is able to earn a higher rate of return on the borrowed funds than the interest rate being paid, he or she is able to keep the excess without any gift taxes being paid.

For example, if a parent makes a nine-year loan to a child of $2 million, the loan will be a successful estate planning tool if the child can earn over 1.63% with the money borrowed. If the child invests the $2 million for the nine years at a 5% annual rate of return, he or she will have about $3,102,656 at the end of the loan, and will only have to repay his or her parents $2,313,275 throughout the course of the loan. Therefore, the child is entitled to keep the difference of about $789,381 without any gift tax consequences. If the parent was going to make the same investment that the child made anyway, the risk to the family as a whole has not changed and the loan was a successful way to transfer wealth to the next generation.

Other Benefits

Outside of a wealth transfer concept, intra-family loans also may be more beneficial than third-party loans because they allow the total interest expense paid over the course of the loan to stay within the family rather than being paid to a bank. In addition, an intra-family loan can allow children who have poor credit history to buy a home or to start a new business. Furthermore, it allows families to avoid the normal expenses incurred with loans, such as administrative costs, closing costs and appraisal fees. Also, if a child wants to pay off the loan early, the terms of the loan can be structured so that there are no prepayment penalties.

Additional Tax Benefits

The IRS allows any individual to make a gift to another person free of the gift tax each year up to the amount of the annual exclusion, which is currently $13,000. In addition to the annual exclusion, every person is allowed a $5 million lifetime exemption from the gift tax. Therefore, even if an individual gives more than $13,000 to a single person in a given year, the gift amount which is above $13,000 will not be subject to tax unless the individual has already given $5 million in taxable gifts throughout his or her life.

Because intra-family loans are not gifts, they do not count towards an individual's lifetime gift tax exemption. Therefore, even if an individual has used up all of his or her $5 million lifetime exemption from the gift tax, he or she can still make a loan to a family member without paying gift tax. Furthermore, a grandparent can make a loan to a grandchild without being subject to the generation-skipping transfer tax.

In addition, an intra-family loan can be used to take advantage of the $13,000 annual exclusion. A parent can forgive up to $13,000 per year per family member (and up to $26,000 if a married couple splits the gift or makes his or her own gift) without any adverse gift tax consequences. However, the parent will have interest income in any year in which interest is forgiven.


An intra-family loan can be used as a simple and effective wealth transfer device. Such a loan is a successful estate planning tool if a family member earns a higher return on the money borrowed than the AFR, thus today's low AFR presents an opportunity to lock in a low interest rate on an intra-family loan.