Be the Bank: Intra-Family Loans & The AFR Strategy
Be the Bank: Intra-Family Loans & The AFR Strategy
Stop giving your children money; lend it to them. How to use the “Applicable Federal Rate” (AFR) to transfer millions to the next generation without triggering a single cent of Gift Tax.
Executive Summary
- The “Gift” Trap: You give your daughter $2M to buy a house. The IRS views this as a taxable gift. It eats up $2M of your Lifetime Exemption. Do this a few times, and you expose your estate to a 40% death tax.
- The Solution (The Family Bank): Instead of gifting, you **lend** the $2M to her. You charge the absolute minimum interest rate required by the IRS, known as the **AFR (Applicable Federal Rate)**.
👉 Why? A loan is not a gift. It uses **$0 Exemption**. - The Arbitrage (Wealth Transfer): If the AFR is 4% and the house appreciates at 8%, the spread (4%) is wealth transferred to your daughter **tax-free**. She keeps the growth; you just get your principal back plus a tiny bit of interest.
The “Paper Trail” Requirement
IRS Red Flag: If you lend money but never collect interest, the IRS calls it a “Sham Loan” and reclassifies it as a Gift.
👉 The Defense: You must act like a real bank.
1. Sign a formal **Promissory Note**.
2. Secure it with collateral (e.g., a Mortgage on the house).
3. Actually collect the interest payments annually. (You can gift the interest back later, but the structure must be rigid).
Mechanic: The AFR Hurdle Rates
Simulation: Funding a $2M Startup Investment
| Feature | Commercial Bank Loan | Family Bank (AFR Loan) |
|---|---|---|
| Interest Rate | Market Rate (High + Spread) | IRS Minimum (Lowest Legal) |
| Approval | Credit Score / Income Check | Relationship / Character |
| Interest Income | Goes to Bank | Stays in Family (Parent) |
“Rich families do not liquidate assets to pay for a child’s house; they encumber assets. By becoming the lender, you teach financial discipline (repayment) while transferring wealth (appreciation) under the radar of the IRS.”