Banks are being criticized both for insufficient lending and for making too much profit. While some of these claims are dubious, there is one bank indisputably offering ultra-low rates with potentially high lending capacity: the Bank of Mom and Dad.
Loaning money to children, whether adolescents or adults, is a valuable way to increase family wealth, provide opportunity and avoid burdensome gift and estate taxes. With interest rates and asset values both low, now is the perfect time to consider a low-interest family loan.
Under current law, 2010 does not have an estate tax. However, in 2011, the exemption level will revert to its 2001 level of $1 million. So even though the estate tax is gone for now, you should not count on it staying that way.
The amount that you can pass to heirs tax-free before your death is also limited. Each year, any individual taxpayer can give only a limited amount to any other individual (including their child) without having to report the gift. For 2010 the cap is $13,000. Gifts beyond that amount count toward a lifetime limit on tax-free gifts, set at $1 million. Gifts above the $1 million lifetime exemption are subject to the gift tax. In 2010 the top gift tax rate is 35 percent.
Family loans offer a way to reduce or avoid these gift and estate taxes. It works like this: A parent makes a loan to a child, which the child can then invest, seeking to earn more than the annual interest he or she pays. If the parent had invested the money directly, those gains would belong to that parent and could potentially be subject to estate or gift tax when passed on to the child. Instead, using the loan strategy, the excess rate of return goes directly to the child, or a trust for the child’s benefit, with no gift taxes.
The Internal Revenue Service sets a minimum interest rate that individuals must charge for a loan not to be categorized as a gift. This rate, known as the Applicable Federal Rate, changes monthly based on prevailing market interest rates. Most financial institutions charge much more than this, but the Bank of Mom and Dad is free to charge just the minimum. Since this rate is currently low, and asset values are also down, a child who receives a loan from his parent at the minimum rate should have little difficulty investing the money at a net profit.
Children have several sound options for their family loan. They might use the borrowed money to buy investment securities, to purchase a personal residence or investment property, or to buy all or part of a family business.
One option is a diversified portfolio of investment securities, which, though volatile, generally have a high expected rate of return over a long period of time. The Applicable Federal Rate in August 2010 for a nine-year loan is 2.18 percent, so all earnings in excess of that annual rate would be transferred to the borrower, free of gift and estate taxes.
Yet another way to use family loans is to provide a mortgage. Since residential real estate values are currently low, but may rebound in the future, buying a personal residence with a low-interest family loan makes good financial sense. If the Bank of Mom and Dad is open for business, it can lend to Junior at low interest rates, using the home as collateral. In fact, Junior can borrow 100 percent of the acquisition price without any need for mortgage insurance. Our firm encourages families to consult an attorney to draw up a formal mortgage and promissory note. The child should also obtain adequate homeowner’s insurance, just as a bank would require him to do. If Mom and Dad lend for 30 years, the minimum fixed rate for a transaction of this kind completed in August 2010 is 3.79 percent.
Family loans can also be used for business succession. Suppose that Ray owns a restaurant that he intends to pass on to his son, Ray Junior. To avoid gift and estate tax, Ray Senior can sell the land and buildings to his son, while at the same time granting him a loan to fund the entire purchase. Ray Junior then signs a promissory note — for instance, a nine-year interest-only note at 2.18 percent.
As the landlord, Junior now charges the restaurant rent, which Senior can deduct as a business expense. After paying the annual interest on the loan, Junior can use the excess rental income to pay down the debt. When the nine-year period ends, Junior can repay the remaining balance on the loan, or refinance it with Senior or another lender. Junior will be well on his way to owning the family business without gift tax worries.
Family loans are most effective when interest rates are low and expected appreciation on investments is high. This leaves a large spread between what the child is required to pay in interest and what he or she can earn with the borrowed money, maximizing the amount that is transferred from the older generation to the younger generation. Family loans can also provide children with opportunities not otherwise available, like purchasing a home, investing in a securities portfolio or acquiring a stake in a family business.
The Bank of Mom and Dad offers low interest, a high lending capacity, and great perks. It’s a family recipe that everyone will appreciate.
by Jonathan Bergman, CFP®, EA, is an associate of Larry M. Elkin, CPA, CFP®, is president of Palisades Hudson Financial Group a fee-only financial planning firm heiadquartered in Scarsdale, NY. It offers estate planning, insurance consulting, trust planning, cross-border planning, business valuation, family office and business management, executive financial planning, and tax services. Its sister firm, Palisades Hudson Asset Management, is an independent investment advisor with about $950 million under management. Branch offices are in Atlanta and Ft. Lauderdale. Website: www.palisadeshudson.com.