In 2011, we’ve seen market volatility nearly as high as it was during the peak of the depression in 2008. At the same time, interest rates are so low that cash invested in money-market funds or CDs is returning almost nothing. What can an investor do to generate a reasonable return on his or her cash without having to take on inordinate risk?
One way is through an intra-family loan, typically from a parent to an adult child. The advantage to the parent is a higher return than CDs and bonds, while the child is able to borrow at a lower interest rate than that offered by a financial institution.
Intra-family loans are commonly used to support children with first-time borrowing (such as for a house), for financing startup businesses or for the purchase of investment properties. You can even loan your son or daughter money for college rather than paying for it yourself, although you should discuss the tax consequences of such a move with your accountant or financial planner.
It’s important to write such a loan using the applicable federal interest rate established by the government for short-, mid- and long-term periods. This is to ensure that the rates are not considered “below-interest” by the IRS, which could result in gift taxes being applied to the parent. To access the latest rates, visit www.irs.gov/app/picklist/list/federalRates.html.
If you’re lending against a house, you should additionally hire a lawyer to draw up a formal mortgage and promissory note. The borrower should also obtain adequate homeowner’s insurance, just as a bank would require. If the loan is unsecured (e.g., education financing), a simple promissory note should suffice. Because the interest portion of each payment is income to you (and consequently taxable), be sure to report the total to the IRS each year on your tax return.
The biggest risk to the lender – that the borrower defaults on the payments or even on the principal – may be small when the borrower is his or her child. On the one hand, the child may be more conscientious about paying the loan back because it’s for the benefit of his or her parents. On the other hand, the parent may not care if the child defaults if the money would have been given as a gift in any case.
There are also estate-planning benefits to an intra-family loan.
Often, such a loan is forgiven if a lending parent dies. And making real estate loans to children (rather than the parent owning the property) removes the appreciation of the property from the parent’s estate.
Intra-family loans are not without risk. But they represent an additional tool that can help other family members while at the same time improving your own cash flow.
Artie Green, a Los Altos resident, is a certified financial planner and professional investment adviser. For more information, call (408) 747-1222. To read his blog, visit blog.pwjohnson.com.
