Low interest rates? Move wealth downstream.

• Author: Beck, Allen M.
• Position: Taxation of loans

With interest rates significantly below historic averages, individuals have been encouraged to borrow at low cost to refinance their homes and other loans. However, these low interest rates are not only applicable to consumer and commercial lending. The IRS's published applicable Federal rates (AFR) are also at their lowest level in decades, which presents a number of planning opportunities for moving wealth to younger generations with little or no gift tax implications.

The short-term AFR, which is the rate used to measure the tax implications of loans with a term not exceeding three years, was 1.23% for July 2003 (compared to 2.84% in July 2002, 4.07% in July 2001 and 6.6% in July 2000). These low rates make this a good time to structure family loans and sale/gift transactions.

Intrafamily Loans

Lending money to a child or grandchild, for example, to assist with (1) a home purchase, (2) funding home improvements, (3) starting a business or (4) providing cashflow for other purposes has never been more attractive. Intrafamily loans may be made without gift tax implications as long as the lender charges interest at a rate no less than the AFR. With appropriate planning, an intrafamily loan can provide a significant benefit to a second-generation family member with relatively modest tax implications to the first-generation family member. Not only can such loans be made at rates lower than those commercially available, but the payment terms can be designed to fit a borrower's specific needs. Balloon notes that call for the payment of interest only currently are an attractive way to provide liquidity without the immediate burden of substantial loan payments.

Example 1: X is in the 35% top Federal income tax bracket and lends $250,000 via a 30 year promissory note to his son and daughter-in-law, H and W, so that they can purchase a new borne. The note is seemed by a mortgage. The interest rate is 4.17% (the July 2003 long-term AFR) and is payable on December 31 each year (interest only); the principal is due at the end of the 30 year term. X decides on a year-by-year basis whether to forgive or collect the interest, depending on his own needs.

If X forgives the interest at the end of the loan's first full year, he will be forgiving $10,425, which is less than the $22,000 combined total in annual exclusion gifts he can make to H and W in 2003. The tax rules still require him to report the forgiven interest for income tax purposes, but the...