Personal Finance | June 22, 2021

Family Loans: Should You Lend It or Give It Away?

It may be better to give than to receive—but what about to lend?

Many well-off individuals choose to extend a helping hand to family members, be it a down payment on a new home, a bridge loan when times turn tough, or even an advance on an inheritance. But how they give can be as consequential as how much.

That’s because of the potential tax implications that depend on whether such financial assistance comes in the form of a family loan—to be paid back at a later date, with interest—or an outright gift. And while loans are often seen as furthering financial discipline, gifts may be less likely to foster conflict because—by definition—they often come without formal strings attached.

So, which method is right for your family and under what circumstances? Start by considering the following.

Gifts

Gifts of $15,000 or less per recipient fall under the annual “gift exclusion” for tax purposes. If your gift exceeds that amount, you must report it to the IRS on Form 709. That doesn’t necessarily mean you’ll owe taxes on it, thanks to the lifetime gift tax exemption, which is the total amount you can give away tax-free during your life. 

The current gift and estate tax exemption for 2021 is $11.7 million per individual (U.S. residents only) under the Tax Cut and Jobs Act (TCJA). This amount is indexed for inflation through December 31, 2025, when it would decrease by 50% under current law. From what we’re seeing in Washington, the sunsetting of the TCJA is unlikely. 

Nevertheless, several legislative proposals that are expected to form new tax rules in October 2021 include the $3.5 million estate tax exemption that President Joe Biden proposed on the campaign trail. Furthermore, Sen. Bernie Sanders has proposed an additional $1 million lifetime gift exemption in his For the 99.5% Act. 

Concrete specifics haven’t been released, and changes are likely before any new tax rules are finalized. We’ll discuss more about the potential tax implications below. (See “Keep your eyes on Washington.”) Keep in mind that if passed, the new estate exemptions may be enacted as early as January 2022. 

“If you have significant means, and you’re primarily concerned with your tax exposure, then it may be prudent to give money or other assets to family members before this window closes, and clients should be meeting with their attorney’s now,” says Chris Borzych, a Schwab wealth strategist in San Antonio, Texas.

“For many individuals, estate taxes haven’t been a concern with the high $11.7 million exemption, which is effectively doubled for a married couple,” Chris explains. “With expected changes and the likely reduction of these exemptions, making transfers out of one’s estate will become a significantly more important planning strategy for us all.”

Furthermore, in November 2019, the IRS issued final regulations to the TCJA that provided a special rule allowing the taxpayer’s estate to calculate the estate tax credit using the higher of either the basic exclusion amount of gifts over a lifetime or the current exemption amount at the time of the taxpayer’s death. Therefore, taxpayers who take advantage of the increased exemptions now before changes this year or in 2026 don’t have to worry about losing the tax benefit of the higher exclusion levels if they’re reduced. 

Gifts are simply outright transfers of assets during your life with annual exclusions and the added benefit of lifetime exemptions. Sometimes, individuals may expect the recipient to pay back the money, want to earn income from an asset, or have even exceeded their lifetime gift exemptions. When this is the case, then gifting your money may not be the right answer.

Loans

For those who don’t want to give an outright gift, an intrafamily loan—which can encourage fiscal discipline in the form of regular repayments—is another way to go. “A family loan can provide support for family and income for the lender,” Chris suggests. 

Before you extend a loan to family, however, be aware that it’s not as simple as just writing a check. The IRS mandates that any loan between family members be made with a signed written agreement, a fixed repayment schedule, and a minimum interest rate. (The IRS publishes Applicable Federal Rates (AFRs) monthly.) 

“There are many strategies that take advantage of the difference between the very low AFR rates, which are currently close to 2% for long term, and the earnings rate a portfolio could potentially earn over time. This may allow a gift and estate tax-free transfer of wealth to family,” Chris says. 

Should you fail to charge an adequate interest rate, the IRS could tax you on the interest you could’ve collected but didn’t. What’s more, if the loan exceeds $10,000 or the recipient of the loan uses the money to produce income (such as using it to invest in stocks or bonds), you’ll need to report the interest income on your taxes.

There’s also the question of delinquency to consider. When a family member can’t repay a loan, the lender rarely reports it to a credit bureau, never mind a collection agency. However, should the lender want to deduct a bad loan on her or his taxes, the IRS requires proof of an attempt to collect the delinquent funds. 

Conversely, if the lender wants to forgive the loan, the unpaid amount will be treated as a gift for tax purposes. Then, the borrower may owe taxes on the remaining unpaid interest. (The rules are even more complicated if the loan is considered a private mortgage, so it’s best to consult a qualified tax advisor or financial planner before finalizing the details.)

“You should not attempt to disguise a gift as a loan,” Chris warns. “An intrafamily loan needs to have a formal structure or else the IRS will consider it a gift. This may be a significant issue if you’ve already used your lifetime gift exemption and, if so, may trigger an immediate tax. 

“With the current unified estate tax and gift tax exemption limits of $11.7 million, this is often not an issue. But if the gift tax exemption is lowered, as under the For the 99.5% Act, then this could be significantly more problematic,” Chris cautions.

Be that as it may, lending a large sum to a family member can help her or him save a tidy sum in interest payments over the life of the loan.

All in the family

Intrafamily loans, which can be offered at rates lower than those for mortgage and personal loans, can help borrowers save big on interest.

 

Intrafamily loan

Mortgage

Personal loan

Loan amount

$100,000

$100,000

$100,000

Interest rate

2.08%*

2.37%

11.40%

Loan term

15 years

15 years

15 years

Total interest paid

$16,495.83

$18,923.64 

$109,131.22

*IRS.gov, June 2021 rate as of 05/2021. Total interest paid assumes a fixed interest rate compounded annually and a loan term of nine or more years.
†Bankrate.com, average rate as of 05/20/2021. Total interest paid assumes a 15-year fixed-rate mortgage and a 20% down payment. 
‡Bankrate.com, average rate as of 05/20/2021. Total interest paid assumes a fixed interest rate and a credit score from 720 to 850. 
The example is hypothetical and provided for illustrative purposes only

For estate-planning purposes, you might consider using an intentionally defective grantor trust (IDGT) along with a large intrafamily loan, especially if the beneficiary is your child or grandchild. Don’t be thrown off by the name. The defect is a tool used to allow greater family transfers by taking advantage of the differences in income tax law and gift and estate law. 

With an IDGT, you can transfer assets to the trust by gift or sale. Gifting an asset could trigger a gift tax on any capital gains. On the other hand, selling an asset can be structured as a loan where you could charge a low interest rate. You won’t owe taxes on the interest income, and the assets will grow tax-free. You must, however, continue paying taxes on all income produced by the IDGT each year. The trust assets won’t be included in the value of your estate, thus lowering your taxable estate and allowing your beneficiary to avoid gift taxation.

Using an IDGT in conjunction with an intrafamily loan is complex. Seek the advice of an estate planning attorney, and reach out to a Schwab wealth strategist to determine if this strategy is right for you.

Keep your eyes on Washington

Two Senate bills introduced in March 2021 could impact your decision to give away your money or lend it. If passed as written, both bills could change how gifts and estates are taxed, rendering IDGTs useless.

As we mentioned earlier, the For the 99.5% Act proposes to reduce the current federal estate tax exemption from $11.7 million to $3.5 million for individuals ($7 million for married couples). It would also lower the current federal lifetime gift exclusion from $11.7 million to a mere $1 million per person. The annual gift tax exclusion would go from $15,000 to $10,000 per recipient and be capped at $20,000 total (all recipients).

Instead of a flat estate tax rate of 40%, estates would be taxed progressively with rates ranging from 45%–60%:

  • Gifts between $1 million and $3.5 million: 40% tax rate
  • Estates and gifts valued between $3.5 million and $10 million: 45% tax rate
  • Estates and gifts valued between $10 million and $50 million: 50% tax rate
  • Estates and gifts valued between $50 million and $1 billion: 55% tax rate
  • Estates and gifts valued more than $1 billion: 65% tax rate

Most importantly, assets in the IDGT would be included in the value of your estate and would be considered a gift (versus a loan) if the grantor-trust status ends before your death. All distributions from the trust during your lifetime would also be classified as a gift.

If the For the 99.5% Acts passes as is, exemption amounts and rates would take effect the next calendar year. Although existing IDGTs would be grandfathered, any transfers would not. Other changes would become effective immediately.

The tax implications are more straightforward under the Sensible Taxation and Equity Promotion (STEP) Act, introduced by Sens. Chris Van Hollen, Cory Booker, Sanders, Elizabeth Warren, and Sheldon Whitehouse. Under the STEP Act, assets transferred by gift, trust, or death would be treated as a sale and taxed as unrealized capital gains. 

The bill would exclude the first $100,000 of cumulative capital gain from lifetime gifts as well as the first $1 million of capital gain from transfers at death. If the STEP Act becomes law, it would be retroactively applied to all transfers made after December 31, 2020.

Family dynamics

In the end, whether to give a gift or extend a loan may come down to the strength of your familial relationships and the nature of the individuals involved. “When developing the right strategy for unique family situations, individual circumstances must be recognized,” Chris says. “Both gifts and loans have a purpose and should be used in an overall strategy. Often, strategies use both to accomplish a client’s wealth-transfer goal.”

Whichever path you take, communication is key, particularly when setting expectations.

What You Can Do Next

  • Read more about managing lifetime gifts.

  • Need help deciding whether to gift or lend money to a family member? Call 800-355-2162 to speak with a Schwab investment professional.