InvestingRetirementTax Tips
Intra-Family Loans & AFR Strategy: Wealth Transfer at the “Risk-Free” Rate
Intra-Family Loans & AFR Strategy: Wealth Transfer at the “Risk-Free” Rate
โ ๏ธ STRATEGY DECLARATION
This strategy is widely accepted in professional practice, but its success depends entirely on the existence of a “Bona Fide Creditor-Debtor Relationship.” If the lender (parent) fails to collect interest or enforces repayment loosely, the IRS will reclassify the entire transaction as a taxable gift.
This strategy is widely accepted in professional practice, but its success depends entirely on the existence of a “Bona Fide Creditor-Debtor Relationship.” If the lender (parent) fails to collect interest or enforces repayment loosely, the IRS will reclassify the entire transaction as a taxable gift.
* Note: This is an L2 ($5M+) foundational framework used in almost all advanced estate freezes (IDGT, BDIT).
Core Definition: “An Intra-Family Loan is a legally documented loan between family members at the minimum IRS-mandated interest rate (AFR), designed to shift investment returns above that rate to the next generation free of Gift Tax.”
* Warning: A handshake deal is not a loan; it is a gift. Paperwork is mandatory.
Core Definition: “An Intra-Family Loan is a legally documented loan between family members at the minimum IRS-mandated interest rate (AFR), designed to shift investment returns above that rate to the next generation free of Gift Tax.”
* Warning: A handshake deal is not a loan; it is a gift. Paperwork is mandatory.
๐ WHO THIS IS FOR (Prerequisites)
- Required Profile: Parents with liquidity who want to help children buy a home or start a business, but wish to avoid using their Lifetime Gift Exemption ($13.6M).
- Primary Objective: Wealth Arbitrage (Allowing children to keep the “Spread” between the investment return and the low AFR interest rate).
- Disqualifying Factor: Children with no ability to repay (Sham Transaction) or parents who intend to “forgive” the loan annually without reporting it correctly.
โ ๏ธ STRATEGY ELIGIBILITY CHECK
This strategy works only if you act like a bank. It fails immediately if:
- โ๏ธ Minimum Rate (AFR): You must charge at least the Applicable Federal Rate (published monthly by the IRS). Charging 0% interest triggers “Imputed Interest” rules, creating a taxable gift phantom income event.
- โ๏ธ Written Promissory Note: The loan must be evidenced by a signed note detailing the interest rate, maturity date, and repayment schedule.
- โ๏ธ Actual Repayment: Interest must be paid annually (or accrued strictly). If the child stops paying and you do nothing, the loan becomes a gift.
EXECUTIVE SUMMARY
- The Premise: You want to give your child $1M to invest. A direct gift uses $1M of your exemption.
- The Structure: You Lend $1M to your child at the Mid-Term AFR (e.g., 3.5%).
- The Mechanism: The child invests the $1M and earns 10% ($100k). They pay you 3.5% interest ($35k).
- The Result: The child keeps the remaining $65k (6.5%) profit. This wealth transfer is Free of Gift Tax. You simply pay income tax on the interest received.
- Conditional Outcome: If the child’s investment loses money, the strategy backfires (they still owe you the debt). It is an arbitrage play.
“The rich do not give money to their children; they lend it.” Lending allows leverage. Gifting destroys leverage. Source: J.P. Morgan Private Bank / IRS Section 7872
๐ MODEL METHODOLOGY & ASSUMPTIONS
- Loan Amount: $1,000,000.
- Term: 9 Years (Mid-Term AFR).
- Interest Rate (AFR): 3.5% (Hypothetical).
- Investment Return: 8.0% (S&P 500).
- Comparison: Loan Strategy vs. Commercial Bank Loan (7.5%).
Performance Simulation (The Arbitrage Spread)
| Metric | Commercial Loan (7.5%) | Intra-Family Loan (3.5% AFR) | Delta (Wealth Shift) |
|---|---|---|---|
| Principal Invested | $1,000,000 | $1,000,000 | – |
| Gross Return (8%) | $80,000 | $80,000 | – |
| Interest Expense | ($75,000) (To Bank) | ($35,000) (To Parent) | Family keeps interest |
| Net Profit to Child | $5,000 | $45,000 | 9x More Wealth |
| Wealth Kept in Family | $5,000 | $80,000 ($45k Child + $35k Parent) | No Leakage to Bank |
*Chart Note: The “Family Unit” retains 100% of the return ($80k). The only friction is the income tax the parent pays on the $35k interest income. The $45k profit transfer to the child is completely tax-free.
Advanced Mechanics: Forgiving the Debt
*How to turn a loan into a gift slowly.
| Strategy | Mechanism | Benefit |
|---|---|---|
| Annual Exclusion Forgiveness | You can forgive up to the Annual Gift Exclusion amount ($19k in 2025) of the principal each year. | Effectively gifts the loan principal over time without using Lifetime Exemption. |
| Interest-Only Note | Structure the loan to pay only interest for 9 years, with a balloon payment at the end. | Maximizes the capital available to the child for compounding during the term. |
| Refinancing | If AFR rates drop, you can refinance the note to the lower rate. | Locks in even cheaper capital for the next generation. (If rates rise, the old low rate is locked in). |
Strategic Mechanics: “Imputed Interest” Trap
What if you charge 0% interest?
- The Rule: The IRS pretends you charged the AFR anyway.
- The Consequence:
- Income Tax: You are taxed on the interest you should have received but didn’t (Phantom Income).
- Gift Tax: The foregone interest is treated as a Gift to the child, eating into your exemption.
- The Fix: Always charge exactly the AFR. It is the lowest rate allowed that avoids this mess.
โ BOUNDARY CLAUSE: Operational Limits
- Demand Loans vs. Term Loans: A “Demand Loan” (callable anytime) uses a floating interest rate (Short-Term AFR). A “Term Loan” (fixed years) locks in the rate. Term loans are generally preferred in low-rate environments.
- Use of Funds: If the child uses the loan to buy tax-exempt bonds, the interest they pay you is generally not deductible for them (Investment Interest Expense limitation).
๐ค DECISION BRANCH (Logic Tree)
IF Asset = High Risk (Crypto/Startup):
โข Input: Investment might go to zero.
โข Output: Use Gift, Not Loan. If the asset crashes, the child still owes you $1M. A loan amplifies downside risk for the borrower.
IF Asset = Steady Growth (Real Estate/Index Fund):
โข Input: Expected return > AFR.
โข Output: Execute Intra-Family Loan. Capture the spread tax-free. It acts as an “Estate Freeze” on the $1M principal.
“A gift is a transfer of value. A loan is a transfer of opportunity.” The AFR loan is the most efficient opportunity transfer tool in the tax code.
Disclaimer: This content is for educational purposes only. Intra-family loans must be bona fide debts with an intention to repay. If the IRS determines the loan was a disguised gift from the start, they will assess gift taxes and penalties. Interest income is taxable to the lender. Consult a CPA for proper documentation.