Top Tax Tip #7. Intra-Family Loans
For families with estates that would otherwise have to pay the wealth transfer tax, intra-family loans have the capacity, when interest rates are low, to provide substantial tax-free transfers. The key to taking advantage of this benefit is when parents loan money to their children at a low interest rate and the children then invest the loaned money at a higher rate. In effect, the difference between the loaned rate and the new income constitutes a tax-free transfer of wealth to the children.
The minimum interest rate is defined as the applicable federal rate (AFR) for the month in which the loan takes place. If the loan is for three years or less, the short-term AFR is used; for loans with a length of 3 to 9 years, the midterm AFR is the right choice; and if the loan has a term that’s more than nine years, the long-term AFR is appropriate.
In January 2019 the semiannual AFRs were:
Short-term AFR 2.72%
Midterm AFR 2.89%
Long-term AFR 33.15%
Here’s a good example:
A father loans his son $1,000,000 in January 2019 with a 12-year, interest-only balloon note. The interest rate is 3.15%. The son invests the money and produces a 10% after-tax return. By the end of the 12-year period, the son’s investment has grown to $3,138,428. The amount due after 12 years is $1,450,878… but the difference of $1,687,550 is the amount of wealth that was transferred tax-free.
An intra-family loan can also be used to reduce interest payments on a mortgage. For example, a parent has a child with a $400,000 30-year mortgage at a 7% interest rate that permits prepayment. The monthly mortgage payment is $2,600. The parent loans the child $400,000 to pay off the mortgage, and the new loan has a 20-year term with interest at 3.15%, which is the required rate of the long-term AFR. This new intra-family loan reduces the monthly payment to $2,200 and decreases the loan term by 10 years, a significant advantage.
Of course, for this to be a valid loan in the eyes of the IRS, the family must obey all loan formalities such that this loan would be the same if the parties were unrelated.
Mortgage loans could be especially helpful for family by providing benefits for both the parents and the children. Children are likely to benefit from the following:
1. A lower interest rate for the loan
2. Probably more flexibility with the terms
3. Avoiding fees like ordination and other transaction costs
4. Able to borrow with a poor credit rating
5. Borrowing with a low interest rate even with a poor credit rating
6. The possibility of not having to make a down-payment
The lending parents may also have some benefits, such as:
1. Helping their children reduce costs
2. Retaining interest payment funds in the family
3. Creating returns for an income stream that might exceed the returns on CDs or bonds
If you think an intra-family loan could help your children and also be a benefit for your own financial circumstances, consider having a discussion with a financial planner who can look at your particular situation and give advice that precisely fits your circumstances.
Top Tax Tip #8. Opportunity Zones
The Tax Cuts and Jobs Act (TCJA) of 2017 was created to offer tax benefits to investors willing to invest in a qualified opportunity zone. A qualified opportunity zone is a lower income area that’s been designated by the government for the employment of capital that could help a community with funds that might otherwise be unavailable because of the asset holder’s reluctance to incur a capital gains tax.
The TCJA offers three incentives for allowing the shift of capital gains earned through the sale or exchange of property into a qualified investment in a low income community:
1. The deferral of gain recognition earned on the original investment: When an investor chooses to reinvest the capital gains achieved from another investment, any gain from that investment will not be included as income until the earlier of either the date in which the investment is concluded, or December 31, 2026. This incentive has no restrictions on the amount of gain that can be deferred.
For example, an investor sells stock with a basis of $300,000 and has a $100,000 capital gain. Rather than paying tax on the $100,000 gain, the investor uses the $100,000 as an investment in a qualified opportunity zone and can now defer all gains made.
2. A basis step-up for the original investment: An investor’s basis in the original investment begins at zero per the opportunity zone rules. When the investment is held for a minimum of five years, this basis increases by 10% of the deferred gain. If the investment continues for a total of seven years, the basis increases by 15%.
For example, an investor chooses to invest $100,000 of capital gains, and keeps the money in the opportunity zone investment for over five years. This reduces the gain to $90,000 and decreases the cost of the taxes on those gains. If the investment is held for seven years or more, the gains would be reduced $85,000 with even greater tax relief.
3. The permanent exclusion of gain on investments made in the opportunity zone: If an investment in an opportunity zone was held for a minimum of 10 years, there will be no gain eligible for taxation when the opportunity zone investment is finally sold.
Of course there are specific qualification requirements that must be met. Here are a couple of the key items:
1. The capital gains must be invested within 180 days of a sale or exchange that created the capital gains.
2. The capital gains cannot be the result of a sale or exchange with a related person.
3. If the gain came from an “offsetting-positions” transaction, gain deferral is not allowed.
If you would like to defer the taxation of your capital gains, investing in a qualified opportunity zone could be the right strategy for you and also benefit a low income area with your choice.
We always welcome hearing from you, and if you think one of these two strategies, or any of the other six strategies mentioned in previous months is a good opportunity for you, please give us a call so we can review how we can help you save tax costs, preserve your wealth, and accelerate the value of your estate. Thank you!
Joseph M. Maas, CFA, CVA, ABAR, CM&AA, CFP®, ChFC, CLU®, MSFS, CCIM
Synergy Financial Management, LLC
13231 SE 36th Street, Suite 215
Bellevue, WA 98006