Banks are criticized for inadequate loans and for making too much profit. While some of these claims are dubious, there is one bank that undeniably offers very low-interest rates with potentially high loan capacity: Mother and Father Bank.
Lending money to children, both teenagers, and adults, is a valuable way to increase family wealth, provide opportunities and avoid burdensome gift and inheritance taxes. With both interest rates and asset values low, now is a good time to consider low-interest family loans.
Under the current law, 2010 does not have a land tax. However, in 2011, the release rate will return to the 2001 level of $ 1 million. So, even though inheritance tax is no longer applicable, you don’t have to rely on a tax that remains that way.
The amount that you can pass to heirs tax-free before your death is also limited. Each year, an 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. Prizes above the $ 1 million lifetime exception will be subject to the gift tax. In 2010 the highest prize tax rate was 35 percent.
Family loans offer a way to reduce or avoid this inheritance gift and tax. It works like this: A parent gives a loan to a child, which can then be invested by the child, who tries to earn more than the annual interest he 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.
Free to Charge just The Minimum
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 Mum 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.
Several Choices for the Family Loans
Children have several sound choices for their family loans. They may use borrowed money to buy investment securities, to buy a private residence or investment property, or to buy all or part of a family business.
One option is a portfolio of diverse investment securities, which, although volatile, generally have high rates of return over a long period of time. The Federal Rate that applies in August 2010 for a nine-year loan is 2.18 percent so that all income that exceeds the annual rate will be transferred to the borrower, free of gifts and land tax.
Providing a Mortgage
But another way to use a family loan 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 Mother and Father lent for 30 years, the minimum fixed rate for this kind of transaction which was completed in August 2010 is 3.79 percent.
For Business Succession
Family loans can also be used for business succession. Suppose Ray has a restaurant he wants to convey to his son, Ray Junior. To avoid inheritance gifts and taxes, Ray Senior can sell land and buildings to his son, while at the same time giving him a loan to fund the entire purchase. Ray Junior then signed a promissory note – for example, a nine-year interest note was only 2.18 percent.
Deducting as a Business Expense
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 Mother and Father Bank offers low interest, high load capacity, and large profits. This is a family recipe that everyone will appreciate.