The 'Family Bank' Strategy: How Wealthy Families Lend to One Another Without Wrecking Relationships
Parents and grandparents often want to help their children and grandchildren hit financial milestones such as buying a house, starting a business or paying off high-interest debt. But it can be important to establish terms and conditions so repayment is agreed upon.
A family bank strategy can help lay out the terms like a traditional loan while giving families the flexibility to establish much lower interest rates than traditional loans.
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What is a 'family bank'?
A family bank isn’t a financial institution, but it is structured in a way that makes it easy for relatives to lend money to one another with interest rates lower than what commercial lenders will offer. There can be several potential tax consequences, so families tend to involve professionals. This arrangement can help families pool resources to help with down payments, college tuition and other big purchases.
The loan you receive from a family bank isn’t a gift. You still have to pay it back over time, and that requires documentation and records. Family banks are more common for estate planning, but less affluent families can use the same business model.
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Keeping a family loan from becoming a tax problem
The IRS publishes applicable federal rates (AFRs) that reflect the minimum interest rates you can set for certain private loans, including family loans. The minimum rate varies based on whether the loan is a short-term, mid-term or long-term financial product. If the interest rate is too low, the IRS can treat unpaid interest as "imputed interest," which increases a lender’s taxable income. This treatment can also result in gift-tax issues.
Any interest is treated as ordinary income, but principal payments do not count. You should review AFRs before committing to a loan since those rates are updated monthly. You can save a lot of headaches in the process by working with a tax professional or estate attorney for large family loans.
How to protect the relationship
Family loans can help parents save considerable money while giving their adult children the funds that they need. However, the tax treatment isn’t the only thing you should protect when giving out family loans.
It’s important for families to try to plan property to help ensure no resentment builds as a result of family loans. Every detail should be put in writing to avoid any confusion, including due dates, payment schedule and late-payment rules.
Adult children should agree to set up automatic payments so the lender doesn’t have to personally chase payments. Some family loans may have provisions about what happens if the lender passes away, the borrower divorces or there is a request for the loan to be forgiven. It’s also important for parents to establish if they can lend money at all. Anyone who needs their nest egg intact to make it through retirement may want to rethink lending money to adult children or grandchildren.