In the ongoing difficult borrowing environment, some potential homebuyers have found the best way to finance a purchase is not from a major commercial bank, but from the "family bank" instead through an intra-family loan. And as long as IRS guidelines are followed, the transaction can be remarkably appealing, with more flexible lending terms, IRS-required Applicable Federal Rates that are still lower than commercial mortgage rates, the potential to still deduct mortgage interest payments for the borrower, avoidance of origination and many other mortgage transaction fees, and the simple benefit that all the interest and principal payments ultimately stay in the family. A major downside, however, is that to ensure the IRS truly respects the transaction - and to receive some of the tax benefits as well - formalities of the loan should be honored, including drafting a promissory note, recording the mortgage against the residence in the proper jurisdiction, and completing actual payments of interest and/or principal. Fortunately, a new solution has emerged - a company called National Family Mortgage, that completes all of the required documentation, records the mortgage, helps to service the loan, and even issues the requisite IRS reporting forms, all for a fraction of the cost of a traditional mortgage loan origination fee. While this won't likely mark a great boom in intra-family mortgage lending, it nonetheless makes the strategy far easier for advisors to implement efficiently for clients!

Intra-Family Loan Strategies

The basic principle of an intra-family loan is fairly straightforward - rather than borrowing money from a bank, a family member in need borrows money from someone else in the family, such as a child borrowing money from his/her parents. The benefits of doing so are significant: the interest costs paid by the child stay in the family (to be used by the parents or in the extreme, inherited back by the child in the future!); origination and other transaction fees may be avoided; the borrowing cost for the child is typically much lower than interest rates from the bank; yet (especially in today's environment) the interest rate paid is still better than what the parents may have been able to earn from a bond portfolio.

For instance, in today's marketplace, the parents could loan money to the child for a 30-year mortgage at 2.5%, which is much less expensive than a 30-year fixed rate mortgage at 3.5% (or higher, depending on loan-to-value, the size of the loan, and the borrower's credit score). Yet the parents still generate interest at 2.5%; while meager, that's better than what they'll likely get from CDs (although notably, lending money out as a mortgage is far less liquid for the lender!). In addition, if the loan is a mortgage that is actually secured against the residence the child purchases and is properly recorded, the child can still deduct the mortgage interest paid to the parents! (Of course, the parents will have to report the interest received on their tax return, just like any other "bond" interest.) And the loan can be structured as interest-only to reduce the cash flow obligations to the child (although obviously not amortizing the loan principal decreases the cash flow payments to the parents as well).

An added benefit of intra-family loans, especially as a mortgage for purchasing a residence, is that some of the constraints of traditional loan underwriting are no longer an issue; for instance, family members don't have to charge more for a child with a bad credit score, and can freely provide loans up to 100% of the purchase price without requiring a down payment. The loan could be for a primary purchase, or a refinance, or a renovation, and can even be structured as a 2nd or 3rd lien against the house. One popular strategy is for children to borrow up to 80% using a traditional mortgage for a new home purchase, but borrow money from parents to fund the downpayment for the remaining 20% (recorded as a second lien on the residence).

Of course, the caveat is that engaging in such strategies does create a genuine risk for the lender that the loan interest and/or principal will not be fully repaid (there's a reason why banks require higher rates to compensate for greater credit risks and smaller downpayments!), so the family-member-as-lender should be cautious not to lend funds in a manner where a partial default by the family borrower could actually create financial distress for the family! Similarly, the family-member-as-lender needs to be cautious not to get stuck in too illiquid of a position, although it's always possible to put a demand provision into the family loan (which, of course, still runs the risk that the family-borrower won't be able to refinance or pay back the note in whole in a timely manner!).

A Gift Or A Loan?

An important caveat to intra-family loans is that, to be respected by the IRS, they really must be loans, and not gifts.

The problem is that the tax code permits individuals to gift up to $14,000 (in 2013) to someone else each year without incurring any gift tax consequences; this amount is called the annual gift tax exclusion. While $14,000 is a lot of money for many families, though, it's very little for others, who would actually prefer to transfer even more money at once to someone else in the family. Unfortunately, though, larger gifts begin to use up the individual's lifetime gift tax exemption, potentially increasing future estate tax exposure.

Consequently, one strategy used in the past to avoid this limitation is to transfer money as a loan, not a gift... and then simply forgive a portion of the loan interest and/or principal every year until the borrowed amount has been extinguished. However, the IRS has scrutinized many of these transactions over the years, often with adverse results; after all, if $100,000 was transferred, no interest was actually paid, and the lender just forgave interest and principal every year for 8 years until the loan was gone, arguably the reality is that the "lender" actually just gifted $100,000 outright in the first year, and the transaction should be (gift) taxed accordingly. In addition, for family loans greater than $10,000, the IRS assumes that interest was paid but forgiven as a gift - which means not only does the lender have potential gift tax reporting to do, but he/she must report on the tax return the imputed interest from the loan as well! (Editor's Note: Some imputed interest exceptions apply for loan amounts between $10,000 and $100,000; see IRC Section 7872(d).)

Over the years, the tax code and case law have been woven together for formulate some guidelines about how to manage an intra-family loan so it is truly respected as a loan, and not a gift.

Intra-Family Loan Requirements

The key to intra-family lending is that, for the loan to be honored by the IRS, it must be treated as a bona fide loan, including loan terms at a "market" rate of interest, proper payments of interest and/or principal, and ideally the formalities of proper documentation (although documentation is not strictly required).

To apply a "market" rate of interest, the loan terms should specify an interest rate at least as high as the so-called "Applicable Federal Rates" (or AFR) which the IRS publishes on a monthly basis under IRC Section 1274. Table 1 of the IRS' AFR guidance includes three rates: short-term, mid-term, and long-term. The short-term rates are for loans with a term of 3 years or less; the mid-term rate is for loans longer than 3 years but shorter than 9 years; and the long-term rate is for loan terms of 9 years or longer.

What's notable, though, is that while the Applicable Federal Rates are considered "market" rates, to the extent that paying intra-family loan interest at this rates avoids gift treatment, they are still remarkably favorable rates; in recent months, the short-term rate has been only 1/4th of 1%, the mid-term rate is just below 1%, and even the long-term rate is less than 2.5%! By contrast, the national average for a 15-year mortgage is about 2.8% (as of the time of this writing), and a 30-year mortgage is almost 3.5%. As a result, intra-family mortgage loans may still be very appealing as borrowing rates, even when the rates are required to be "high enough" to meet the IRS' AFR requirements.

Implementing Intra-Family Mortgage Loans

One of the biggest challenges for many families considering intra-family loans - particularly intra-family mortgages - is simply the administrative work and requirements to complete the loan properly, especially since the loan must be properly recorded against the residence for the interest to be deductible for the borrower (and notably, clear documentation of the loan is also required if the lender ever wants a tax deduction for amounts not repaid in the event the borrower defaults).

In addition, some families actually prefer a more formal loan arrangement; for instance, when the parents-as-lenders truly do intend the transaction as a loan (and not a disguised gift), they want to be certain that the child-as-borrower respects it appropriately and learns some financial responsibility (albeit while still enjoying more favorable loan terms than would be received from a bank, and keeping the loan interest in the family). Alternatively, if the money is being loaned out from a family trust, the trustee will likely wish for the loan to be properly documented and recorded to substantiate that fiduciary obligations to manage the trust corpus responsibly are being fulfilled.

An interesting new solution in this space is National Family Mortgage, a company that functions as the "middle man" to help process and maintain intra-family mortgage loans, handling everything from drafting up the promissory note between the parties, documenting the deed of trust that pledges the property as collateral and recording it in the proper jurisdiction, establishing electronic funds transfer arrangements for loan payments (including escrow for homeowners insurance and property tax, if desired) and sending out payment notices and balance statements, and even issuing the proper IRS reporting forms (the Form 1098 to the borrower for mortgage interest paid, and the Form 1099-INT to the lender for interest received). If the loan is structured as interest-only, the National Family Mortgage service can also help arrange for a portion of the loan to be forgiven annually (which is far less likely to trigger IRS scrutiny when interest is being paid, loan documents are recorded, and all the other formalities of the transaction are being respected).

The cost for the service is a one-time fee of $725 for the loan documents (which, notably, is still far less than the origination fee for a traditional mortgage), an additional recording tax paid directly to the state/county (for jurisdictions that require it), and ongoing loan servicing (with the statements, electronic funds transfer, IRS reporting, etc.) costs $15/month (or slightly more for larger loans, and with an additional $15/month charge for escrow services). Readers of this blog can receive a 15% discount to the one-time fee for any of their clients who utilize the service by entering the coupon code "KitcesBlogDeal" (without the quotes) when the client signs up. (Editor's Note: This is simply a complimentary offer to readers of this blog; there is no financial remuneration or other relationship between Nerd's Eye View and National Family Mortgage.)

Ultimately, intra-family mortgage loans are still a fairly "niche" strategy, as it requires some significant financial wherewithal for the family to afford the loan to children or other family members in the first place. Nonetheless, services like National Family Mortgage make the process significantly easier to implement and administer, and for a cost that is still far less than the origination fee for a traditional mortgage, while simultaneously keep all ongoing interest payments in the family. And at today's Applicable Federal Rates, there's a lot of opportunity for parents to help children or other family members make home purchases more affordable, even while generating what is still a reasonable return given today's low return environment!

(This article was included in the Carnival of Wealth, And Stay Out Edition on Control Your Cash, the Carnival of Investing #13 on Investeem, the Carnival of Financial Planning on My Personal Finance Journey, and also the Carnival of Personal Finance #397 on My Personal Finance Journey.) 

For some further thoughts, see below for a video on intra-family loans recorded with Wealth Channel magazine!


  • http://www.pathfinderfs.com David Jacobs

    Michael,

    While NFM is relatively new, it is actually the latest in a string of incarnations: Circle Lending -> Virgin Money USA -> NFM. So this kind of service has been around a while.

    And I have had client’s successfully use these services.

    David

  • http://www.demmingfinancial.com David

    Your article touches on precisely why our firm has been in the mortgage origination services business for over 25 years. This business activity is not as revenue generation pursuit, but to be in the vortex of family resolution issues which shocking involve, family members and their money. Two recent examples,selling grandma’s house using our co-owned title co with the title agent attorney convenietly drawing the purchase agreement as well as closing docs as well as financing grandson purchaser with the funds being directed to our offices for investment from both father and aunt beneficiaries. Others are refinacing homes at 2.6% to payoff 6.8% school loans with promissary loan agreements and amortization schedules between parent and children.

  • Pingback: refinace house loans « House Loan Refinance()

  • Gem De Leon

    Well, a family bank looks like a good idea but a loan is still a loan. If you don’t know the right ways to pay it, then your finances are doomed. It’s always like that. This is the reason why I bought my for sale Potts Point in cash.

    http://www.rwebay.com.au/buying/search-listings/

  • Jacob Wadsworth

    Can’t it be done internally or make a deal perhaps to loan without interest since it is between family after all. I mean, why does it have to be approved by the IRS? – http://www.mortgagelocators.com/

    • http://www.kitces.com/ Michael Kitces

      Jacob,
      If the transfer within the family does not have a reasonable rate of interest, the IRS deems it to be a gift and may apply gift taxes (or at least force the donor to use a portion of his/her lifetime gift tax exemption).

  • Ronnie Mills

    If you want to write a 7 year mid term loan for your son, are the payments set up to completely amortize it over 7 years, or can you amortize it over 30 years with a balloon payment and still get the mid term rate? After 7 years, we would roll it over into another loan. Thanks

  • Miggida

    so if i get the bank to finance half the house purchase, and my dad loans me 30% as a 2nd mortgage (i still put my own 20% down), will my interest payments to my dad on the 2nd mortgage be tax deductible?

  • Pete

    AFR interest rates change monthly. If a parent and child enter into a 20 year purchase contract on a house at the Annual AFR, is that interest rate locked in for the life of the purchase contract, in essence creating a load with a “fixed” interest rate?

    • http://www.kitces.com/ Michael Kitces

      Pete,
      The family can structure the loan however they wish. If they wish to make it a 20-year fixed rate loan, then write it into the loan, and it’s a 20-year fixed rate loan.

      The fact that the AFR changes on an ongoing basis is simply a recognition that WHEN you make the loan, you have to set it at a ‘current’ interest rate at the time of the loan, just as the going mortgage rates change daily but when you can get a 30-year fixed rate loan (anchored at the rate that was available at the time you took out the loan). There is an AFR specifically intended for “long-term” loans.
      – Michael

  • Rob Oliver

    Michael,
    Would you mind speaking to taxes and loan forgiveness for intra-family loans?
    Say the parents’ estate planning documents forgive the loan at their deaths. I assume the value of the loan would be included in their estate and be subject to estate taxes if applicable. Is that right? And is the loan forgiveness taxable income to the kids?
    Many thanks!

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Michael E. Kitces

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