Mortgage Rates Too High? Consider an Intrafamily Loan

With home prices and mortgage rates skyrocketing over the last few years, many young folks are being squeezed out of the real estate market. While starter homes are difficult to come by, qualifying for a mortgage requires much more underwriting than we saw 20 years ago. Parents and grandparents often want to help by making gifts for down payments or lending the funds to successor generations.

Intrafamily loans offer a flexible and often financially advantageous option for borrowing and lending. Unlike traditional loans from banks or other financial institutions, these loans leverage the trust and relationship within a family, allowing for more personalized terms and potentially lower interest rates. However, to ensure these loans benefit all parties and avoid potential pitfalls, it’s crucial to structure them carefully and understand the associated legal and tax implications.

Benefits to intrafamily loans

Currently, (as of June 1, 2024) the 30-year mortgage rate is around 7.16%.¹ Young people can easily benefit from an intra-family loan at a much lower rate. However, to avoid gift tax implications, the rate must at least meet the IRS’s minimum interest rate, known as the Applicable Federal Rate (AFR). The May 2024 long-term AFR is 4.46%, a full 3% lower than the market rate for a mortgage.² This can also benefit the lender since they can lock in a higher rate of return on their funds than may be possible in the bond market, while also maintaining a lien on the home.

The terms of the agreement can be tailored to the family’s needs, offering flexibility in down payments, repayment terms, debt forgiveness, and more. For instance, a recent college graduate might purchase a larger house than they can currently afford, anticipating future salary increases. To support this, the loan terms could be structured with lower payments for the first 5 years, then higher payments after that to properly amortize the loan over the desired timeframe. The loan could be structured as interest-only or with an expectation of debt forgiveness for a portion of each monthly payment.

What about the downsides?

It is said that you should never lend money to friends or family because it can strain relationships. When the borrower struggles to make payments on time the lender may feel obliged to provide forgiveness, which can make them resentful. However, if the lender demands payment, the borrower may feel resentful that a family member is putting them in a tight spot. It is best to avoid the loan if you believe it could form a wedge in your relationship.

There can also be legal complications if proper documentation is not drawn up and signed by each party. The child may argue the money was a gift with no intention of repayment while the parent was counting on the monthly income to cover living expenses. As such, it is imperative to discuss with an attorney or a company such as National Family Mortgage, who can assist with the legal documents, structuring payments, and tax forms.

Lastly, tax implications can be more difficult than you imagine. Straight-forward mortgages will cause the lender to recognize interest income each year and a tax-free return of principal. The borrower will likely get a tax deduction for the interest paid assuming they itemize their deductions.³ Where things get sticky is debt forgiveness. If the IRS can justify a position that the loan was merely a gift in disguise, the entire amount is treated as a taxable gift in the year of inception. Therefore, it is important to establish a legal debt obligation with expectations for the child to pay down the debt, not for each monthly payment to be “gifted/forgiven” by the lender.

This doesn’t mean that forgiving a monthly payment will result in a problem. You may forgive the payment for the month of their birth, Christmas, or another special occasion. However, it shouldn’t be the expectation that every payment is going to be a gift.

When a monthly payment is forgiven, it is a gift for gift tax purposes. The amount of the payment is a present-interest gift, which is normally free of any gift tax. However, the lender must normally impute the interest income as if they received it.⁴ This means income tax is paid on interest income never received.

Intrafamily loans can be a beneficial financial arrangement, fostering support and mutual benefit within a family. However, careful planning, formal agreements, and adherence to legal and tax requirements are essential to ensure that these loans serve their intended purpose without causing undue stress or complications. By approaching intrafamily loans with the same seriousness as a traditional loan, families can help each other financially while preserving their relationships and complying with the law.

For more information, speak with your advisor. And if you are not a Mercer Advisors client, let’s talk.

¹ Bankrate.com

² “Applicable Federal Rates.” Internal Revenue Service.

³ IRC § 163

⁴ IRC § 7872(d)