We are Family – What to Consider with an Intrafamily Loan

In what can only be described as my personal mid-life crisis, we are in the middle of a whole home renovation that has us displaced for up to six months and wondering what we were thinking. Nevertheless, the house has been through the demo phase and is starting in on the rebuild phase as I write this. Our home is not getting any bigger, but she is getting a much-needed update and freshening. For another perspective on the home renovation topic, see Jonathan Stolz’s blog post.

Of course, this process does not come cheap, especially considering the cost of building materials and overall interest rates. When my mother offered to loan us the money so that we could avoid the higher cost associated with current home equity or HELOC rates, while keeping our low-rate mortgage, I had some reservations. We see plenty of clients helping family members in various financial ways. If the need is great enough, and the relationship is strong enough, an intrafamily loan makes a lot of sense. However, it is best to go into this transaction with your eyes open. 

First, intrafamily loans must have a certain structure to make sure they are not considered gifts. A standard promissory note can provide that structure and help to define certain characteristics of the loan for both the borrower and the lender. After going back and forth a few times, I used an online legal forms service to draft a loan agreement and selected the most appropriate applicable federal rate (AFR) to use on the loan. While you can loan family members money and set any interest rate you like, if you use a rate that is less than the AFR, then the difference will be considered imputed income to the lender. As it is, we will not be able to deduct the interest on the loan, but my mother will have to declare it as income.

We opted to structure the loan like a regular mortgage, with a 30-year fixed agreement, secured by the property. I created a payment schedule and am prepared to document each payment against the loan balance. Per my mother’s request, we wrote in a line about the unpaid balance of the loan being deducted from my share of the remaining estate upon her death. It is worth considering that should my mother choose to forgive any balance of the loan prior to her death, whatever that amount may be will count against her lifetime gift and estate tax exemption. 

But before we agreed on anything, I made sure that my brother was aware of what we were doing and had a chance to speak out, if he felt he needed to. I’ve seen previously civil families become somewhat nasty when settling estates and wanted to avoid any hard feelings.

If you decide to go this route, I highly recommend consulting with a professional to help draw up the documents and create a payment schedule. Having an unbiased administrator can take some of the emotions out of the transaction. And while it was my mother’s idea to loan us the money, I can’t help but feeling a personal responsibility towards paying down this debt, regardless of any real need to do so.

 Meet Kristan Anderson, CEBS®, CFP® »

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