The Family Bank Strategy: Why Lending to Your Kids is Better Than Giving
The Family Bank Strategy: Why Lending to Your Kids is Better Than Giving
๐ WHO THIS IS FOR
- Target Profile: Parents with $5M+ Net Worth who want to help adult children without spoiling them.
- Primary Objective: Wealth Transfer & Financial Education (Transferring opportunity, not just cash).
- Not Suitable For: Parents who need the loaned capital back for their own retirement living expenses.
EXECUTIVE SUMMARY
- The Dilemma: If you gift $1M to your child to buy a house, you use up $1M of your Lifetime Estate Exemption. If they get divorced later, that $1M might be split with the ex-spouse.
- The Solution: Establish a “Family Bank.” You lend the $1M to your child using a formal Promissory Note. The interest rate is set at the IRS minimum (AFR), which is often far below commercial mortgage rates.
- The Arbitrage: If the AFR is 4% and the child invests the money to earn 10% (in a business or real estate), the 6% spread creates wealth for the child gift-tax free.
- Authority Baseline: This strategy relies on IRC ยง 7872. As long as you charge at least the Applicable Federal Rate (AFR), the IRS does not consider the loan a gift.
“Give a man a fish, and you feed him for a day. Lend him the money to buy a fishing boat, and you create a dynasty.” Intra-Family Loans are the structural bedrock of generational wealth. They turn the “Bank of Mom and Dad” from a piggy bank into a commercial lender, protecting the assets from creditors and predators. According to Team BMT Analysis, this is the most underutilized tool for families who have liquidity but fear the “trust fund baby” syndrome. Source: National Law Review / Schwab Family Office Handbook
Scenario: Daughter wants to buy a $2M home. Mortgage rates are 7%.
- Commercial Bank:
Loan: $1.6M (20% down). Rate: 7%.
Interest Paid to Bank: ~$112,000/year. (Wealth leaves the family). - Family Bank:
Loan: $1.6M. Rate: 4% (Long-Term AFR).
Interest Paid to Parents: ~$64,000/year. (Wealth stays in the family).
Result: Daughter saves $48,000/year. Parents earn 4% on their cash (better than a savings account). The “Spread” enriches the child without triggering Gift Tax.
BMT Verdict: A gift is an unconditional surrender of capital. A loan is a conditional deployment of capital. In a litigious world, never give what you can lend. A secured loan puts you (the parent) in the “First Lien” position, ahead of any future divorcing spouse or lawsuit creditor.
Interest Rate Comparison (Hypothetical)
| Lender Type | Interest Rate (%) |
|---|---|
| Commercial Bank (Mortgage) | 7.5 |
| Family Bank (IRS AFR Long-Term) | 4.2 |
*Chart Note: The AFR (published monthly by the IRS) is almost always lower than commercial rates because it creates no profit margin/risk premium. By lending at the AFR, you are legally transferring the “commercial spread” to your child tax-free.
Asset Protection Reality: In a divorce, a gift received during marriage is often commingled and becomes “Marital Property” subject to 50/50 split. A Loan is a liability. If your child divorces, the Family Bank calls the loan. The ex-spouse gets nothing of the loan principal because it must be repaid to you. It is the ultimate pre-nuptial firewall.
โ BOUNDARY CLAUSE: This Structure Breaks Down If:
- Lack of Formalities: If you don’t have a signed Promissory Note, don’t record the mortgage (Deed of Trust), or don’t collect interest payments, the IRS will reclassify the loan as a Gift. You must act like a real bank.
- Forgiving Interest: You cannot just “forgive” the interest every year. If you do, it counts as a gift. The child must actually pay it (or you must formally gift the specific amount to cover it using your annual exclusion).
Execution Protocol
Use a formal Promissory Note. Specify the loan amount, the AFR interest rate, the term (e.g., 9 years for Mid-Term AFR, 30 years for Long-Term AFR), and the repayment schedule.
If the loan is for a house, record a Mortgage/Deed of Trust with the county. This makes the interest tax-deductible for the child (mortgage interest deduction) and secures your priority against other creditors.
The parent MUST report the interest received as Taxable Income on their 1040 (Schedule B). This is the cost of the strategy. However, the family unit usually wins because the child’s tax saving (or opportunity cost) exceeds the parent’s tax bill.
The Family Bank is not about hoarding wealth; it is about teaching stewardship. It changes the conversation from “Can I have some money?” to “Can I propose a business plan for a loan?”
WEALTH STRATEGY DIRECTIVE
- Do This: Use a “Refinance” strategy. If your child has a high-interest student loan (8%) or mortgage (7%), pay it off with a Family Bank loan at the AFR (4%). You instantly improve their cash flow without giving them a handout.
- Avoid This: Lending money for consumption (vacations, cars). Lend only for Appreciating Assets (Business, Real Estate, Education). Lending for consumption destroys the family balance sheet.
Frequently Asked Questions
Can I forgive the loan later?
Yes. You can use your “Annual Gift Exclusion” ($18,000 per person in 2024) to forgive $18k of principal/interest each year. Over time, you can melt down the loan tax-free.
What if AFR rates rise?
The AFR is fixed at the time of the loan. If you lock in a 30-year loan at today’s rate, it stays that way even if market rates double. You lock in the low rate for the duration.
Does this work for trusts?
Yes. You can lend to an IDGT (Intentionally Defective Grantor Trust). This is the advanced version (“Sale to IDGT”) where the trust buys assets from you with a note, supercharging the wealth transfer.