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Intra-Family Interest-Bearing Loans: An Effective Gifting Strategy in a Low Interest Rate Environment

February 2015 -

Dear Friends and Colleagues,

Whenever I see something that I think might be of benefit, I am happy to share with you. This article from my valued colleague, George Spiropoulos, CFP®, Senior Vice President, The BlueStone Group at Morgan Stanley, caught my attention. I thought it was particularly relevant given we are at the start of the 2014 filing season and related client contact.

Intra-Family, Interest-Bearing Loans: An Effective Gifting Strategy in a Low Interest Rate Environment

Intra-family loans offer a way for high-net-worth families to transfer assets to children or grandchildren without triggering gift taxes. But you must make sure you adhere to the IRS rules.

For families with significant assets, gifting to children or other family members beyond the annual $14,000 limit means cutting into their lifetime estate and gift allowance of $5.34 million (in 2014). But one effective way to transfer assets without triggering the gift tax is through intra-family loans.1

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 them being deemed gifts, as long as the lender, usually a parent or grandparent, charges interest and the borrower pays back the principal and interest per the terms of the loan. If the borrower invests the loan proceeds at a yield exceeding the interest rate charged on the loan, such amount is effectively “transferred” to the borrower without triggering any gift tax.

A brief example may help to illustrate the point: Assume you make a nine-year, $5 million loan to your child at 1.4% annual interest, compounded annually. Your child then invests the loan proceeds and earns a 7% annual yield. After paying you interest at the end of each year, and repaying the loan’s principal amount at the end of the term, the investment would have a projected value of almost $3.4 million. You would have made a substantial wealth transfer with no gift tax and no future estate-tax consequences.

For this not to be deemed a gift, however, the loan must meet certain terms set out in the Internal Revenue Code. First, you must use an IRS-approved interest rate, called an applicable federal rate (AFR), which the Treasury determines every month. There are three general categories of AFRs: short term, for loans lasting up to three years; midterm, for loans lasting more than three years but not more than nine years; and long term, for loans lasting more than nine years. For loans originating during July 2014, the AFRs were 0.31%, 1.40%, 3.06%, respectively.2

You 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. And if the borrower wants to pay off the loan early, the terms of the loan can be structured so that there are no prepayment penalties. Note that you will have to declare the interest as taxable income on your tax return, regardless of whether it is paid or added to the loan.

The key, of course, is the AFR. During periods of low interest rates, when AFRs are minimal, it is generally easier to invest the proceeds at higher yields. The larger the difference between the two rates, the more wealth will effectively be transferred.

Intra-family loans also pose certain advantages over third-party loans. For one, they allow the interest 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 a 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.

Be aware, however, that there is potential risk should one party not hold up their end of the deal. That’s why it is important to formalize the transaction and involve a financial planner and an attorney. Also be prepared to demonstrate that the loan is legitimate, and that repayments are being made per the terms of the loan. This documentation will also help sort matters out if the lender should die before the full value of the loan has been repaid.

An intra-family loan can be used as a simple and effective wealth transfer device, but make sure you work with a qualified professional.

Sources:

1Internal Revenue Service, Estate and Gift Taxes, 2014.

2Internal Revenue Service, Index of Applicable Federal Rates (AFR) Ruling, July 2014.

Other article sources:

US News & World Report, Borrowing From the Family Bank, Nov 4, 2011.

LifeHealthPro, Estate planning benefits of intra-family loans, February 10, 2014.

The Wall Street Journal, The Benefits of Intrafamily Loans, December 18, 2011.

If you’d like to learn more, please contact George Spiropoulos, CFP®,

Article by Wealth Management Systems Inc. and provided courtesy of Morgan Stanley Financial Advisor.

The author(s) are not employees of Morgan Stanley Smith Barney LLC ("Morgan Stanley"). The opinions expressed by the authors are solely their own and do not necessarily reflect those of Morgan Stanley. The information and data in the article or publication has been obtained from sources outside of Morgan Stanley and Morgan Stanley makes no representations or guarantees as to the accuracy or completeness of information or data from sources outside of Morgan Stanley. Neither the information provided nor any opinion expressed constitutes a solicitation by Morgan Stanley with respect to the purchase or sale of any security, investment, strategy or product that may be mentioned.

George Spiropoulos may only transact business in states where he is registered or excluded or exempted from registration http://www.morganstanleyfa.com/thebluestonegroup Transacting business, follow-up and individualized responses involving either effecting or attempting to effect transactions in securities, or the rendering of personalized investment advice for compensation, will not be made to persons in states where George Spiropoulos is not registered or excluded or exempt from registration.

Morgan Stanley Smith Barney LLC (“Morgan Stanley”), its affiliates and Morgan Stanley Smith Barney Financial Advisors or Private Wealth Advisors do not provide tax or legal advice. Clients should consult their tax advisor for matters involving taxation and tax planning and their attorney for matters involving trust and estate planning and other legal matters.

Morgan Stanley Smith Barney LLC offers insurance products in conjunction with its licensed insurance agency affiliates.

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© 2014 Morgan Stanley Smith Barney LLC. Member SIPC.

CRC 978457 8/14

Robert Fligel

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