Taking advantage of low interest rates.

• Author: Henderson, Tracie K.

Low interest rates can benefit taxpayers in many ways, including converting demand loans to term loans and providing children with financing for major purchases.

Converting demand loans to term loans

Many taxpayers have either lent money to a family member or closely held corporations or borrowed money from them. Many of these loans carry an interest rate equal to the applicable Federal rate (AFR), to avoid imputed interest under Sec. 7872. When such loans are fluctuating demand loans, the AFR that must be charged also fluctuates (Sec. 7872(f)(2)(B)). The AFR that must be charged for term loans, however, is a fixed rate determined on the date of the loan (Sec. 7872(f)(2)(A)). When AFRs are very low, clients should consider converting their demand loans into term loans to lock in the low rates. As always, clients should execute valid notes with specified terms.

Low-interest rate loans to children for home purchases

When AFR rates are low, it may make sense for clients to help their children or grandchildren by lending them money to buy a home. When the long-term AFR is lower than the mortgage rates offered by financial institutions, such loans will offer substantial savings to the children/grandchildren, effectively transferring wealth to them free from gift, estate or generation-skipping transfer (GST) tax. In addition, the children/grandchildren will save on points and other fees. To further sweeten the deal, the parents can give the children/grandchildren a down payment, shielded from gift and GST tax by the annual exclusion.

Example 1: Daughter D and son-in-law S buy a house that costs $200,000. Mother M and father F have offered to give them the 20% down payment of $40,000, and to lend them the remaining $160,000 at 7%. (Assume that the current long-term AFR is 7%.) Without the loan from M and F, D and S would have to borrow from their local bank at 9% plus two points.

This strategy also has an advantage for those clients who want their children to "learn responsibility" and, therefore, are reluctant to give them large sums of money outright. The children must still make the mortgage payments; it just becomes a little less painful.

Variation: loans to children via defective grantor trusts

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