Low-Interest Loans: An Estate Planning Technique

The novel “coronavirus” (also called “SARS-CoV-2”) causes the disease “COVID-19.” It first appeared in late 2019 and was reported to the World Health Organization (WHO) on December 31, 2019.  COVID-19 has impacted the lives of millions of people and countless events around the world.

The coronavirus has caused an unprecedentedly steep increase in unemployment and has roiled stock markets around the world. The resulting low-interest rates open the door to unique estate planning opportunities.

The IRS sets the “Applicable Federal Rate” or “AFR,” which is the rate the Service determines is the going interest rate. As long as you charge at least that rate, you will not be deemed to have made a gift in charging the interest rate. The AFR is set in the middle of the month for the next month. The AFR for May 2020 is historically low. Those rates are .25% for a loan of up to 3 years, .58% for a loan term of 3 to 9 years, and 1.15% for a loan over 9 years duration. The rate for certain estate planning transactions, such as life estate and remainder interests, is .8%.

One common way to help loved ones without using any lifetime exclusion is by lending money at a very low-interest rate. If you charge no interest, then (with an exception for small loans between individuals), the Service will deem that the borrower paid interest to the lender and the lender gave it back to the borrower. This would cause taxable income to the lender and a taxable gift by the lender. (In a future article I’ll examine these so-called “gift loans” under Section 7872.) A loan at the AFR faces no such imputation of income or a gift.

Let’s look at an example: John lost his job due to the coronavirus pandemic. He had a good job at a major retailer that had to close due to stay-at-home restrictions. As a result, John is considering moving his family closer to his mother, Mary, as she’s getting older and needs more help as she ages. Mary has excess funds and decides she wants to benefit John. She wants him to have a good start and wants to make it easier for him and his family to move closer to her. She doesn’t want to use any of her gift tax exclusion as she has other uses for it. She lends John the money for his house, charging interest at the AFR, 1.15% for a 30-year loan (in the month she lends the money). She also lends John money to start a new business. This helps John immensely. He doesn’t have a job and will be moving to a new city. He would have had difficulty qualifying for a loan. Even if he could have gotten a loan, it would have been at a much higher interest rate.

Mary was able to provide a real benefit to John. This helped make it possible for John (and her grandchildren) to move closer to her. It allowed John to save money on his mortgage and business loan. It allowed Mary to help John without using any of her exclusion. It also allowed her to slow the increase in the size of her taxable estate.

This transaction worked to benefit both Mary and John. It allowed John and his family to move closer to Mary and for them to become even closer, both geographically and personally.

Bob