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Keeping It Within the Family

Using professional services, your clients can be the bank. It benefits the child and the parents.

Helen Modly, 02/01/2007

At some point, your clients with adult children will find themselves responding to a request for money from one or more of their children. When they come to you they are often looking for two answers: "Can we afford to loan the money from our portfolio?" and "How do we structure this to be fair?" You will have to use your financial planning skills to determine if they can really afford to make the loan, but understand that parents will often jeopardize their own security to benefit their offspring.

Intrafamily lending is often discouraged because of the emotional issues created when a loved one is late with their payments, defaults altogether, or the loan itself causes jealousy and envy among other family members who are not party to the loan. However, some sources estimate that there are over 10 million people in the U. S. today who have a private loan with a relative, friend or some else they know. Most of these loans are unstructured and undocumented, and about one in six loans proves to be uncollectible. You can help your clients increase the chance of a successful family lending outcome by following these reasonable guidelines.

Get It in Writing
The simplest private loans are similar to an I.O.U. and are usually unsecured with any collateral. For smaller sums, this is probably okay, but when the amount borrowed is significant (and this level varies for each family), it is advisable to create a structured loan arrangement.

The loan itself needs to be documented with a promissory note that spells out the amount borrowed, the interest rate assessed, the specific terms of repayment including timing and amount of each payment due, as well as the expected full pay-off date.

An amortization schedule should be created that allocates the amount of principal and interest to each payment, (many Web sites have programs that will calculate this), and the lender should specify how and when payments are expected to be made. There should be a reasonable penalty assessed for late payments. The lender should expect to keep accurate records of each payment made and the outstanding loan balance.

Charge Interest
A no-interest loan without a specified repayment schedule runs the risk of being considered a gift by the IRS. Especially for wealthier families, having a large loan treated as a gift can have very negative consequences for estate planning purposes, and depending on the amount of the loan, could actually trigger a current gift tax liability for the lender.

If the purpose of the loan is to finance the purchase of a house, then it should be designed and treated as any other mortgage. The lender should record the loan as a deed of trust with the county clerk's office to secure their interest in the property. They should also structure the loan with an appropriate interest rate to avoid having the IRS deem the loan to be a gift. The Internal Revenue Service's Applicable Federal Rate (AFR) is usually considered to be the minimum interest rate such a loan should carry. If these provisions are followed, the mortgage interest is tax deductible for the borrower similar to a regular bank mortgage and there is reduced risk that the IRS will come and re-characterize the loan as a gift subject to gift tax reporting.

Good for the Child
An intrafamily mortgage can allow a first-time homebuyer to obtain needed financing even if they haven't established an acceptable credit history yet. The average interest rate on intrafamily mortgages is 6%--attractive compared to the rates they might obtain as a borrower with an unseasoned credit history, new job and other competing expenses such as car payments and student loans. These loans are often designed with more payment flexibility than would exist with a traditional bank mortgage. The family lenders might agree to reduced payments for the first few years as newly married, or newly graduated children get themselves established financially. Intrafamily mortgages also have lower closing costs on average than bank-originated loans.

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