We have written extensively, and a large portion of our business, is assisting with family transactions in real estate: gifting, sales and inheritance. This article focuses on the issue of what interest to charge for a family loan, specifically in real estate.

Q. Can I loan my child money to buy a home (or for any purpose)? Do I have to charge them interest? What if I don’t charge my child interest?

A. Simple:

• YES, of course, you can loan your child money to buy a home (or for any purpose).

• NO, you do not have to charge them interest.

• But, if you do not charge the IRS’ “Applicable Federal Rate” you must declare the loan’s free interest as a gift or you risk having that loan deemed a gift (after all, there’s no zero percent interest rates from a bank) AND owing back taxes and penalties on the interest you never received!

So, either declare the free interest as a gift, or, charge the Applicable Federal Rate for interest on the loan.

What is the IRS’ “Applicable Federal Rate”

When it comes to family loans — the IRS Applicable Federal Rates are the minimum interest rate you should be charging a “borrower”.

Often well below a fair market value loan (i.e. what you could get from a bank), the IRS Applicable Federal Rates will still fluctuate each month based on a variety of factors including the prior 30 day average market yields of corresponding US treasury obligations.

To ensure to comport with a loan being a “loan” and not a “gift” (and/or some messy complications where the “lender” may have to pay taxes on what interest should have been charged), simply charge the IRS’ “Applicable Federal Rate”.

The applicable rate should be based on the month the loan is made.

What is the Actual Rate of The IRS’ “Applicable Federal Rate”

IRS Applicable Federal Rates fluctuates each month based on a variety of factors and will, generally speaking, go up and down with bank interest rates.

You can find the IRS official rates here: https://www.irs.gov/applicable-federal-rates

There are three AFR tiers based on the repayment term of a family loan:

(1) Short-term rates, for loans up to three years.
(2) Mid-term rates, for loans between three and nine years.
(3) Long-term rates, for loans greater than nine years.

So, for example, for December 2023, a long term loan (more than 9 years) is 5.03%. That’s well below bank rates, but high for anyone still dreaming of covid timeframe historical low rates.

What Else Should I Do To Formalize A Family Loan?

Any loan, even a family loan, should be well documented. In real estate, in California, this generally means a Promissory Note (the actual document spelling out the terms of the loan, duration, payment, interest, etc.) and a Deed of Trust (the actual security instrument recorded against real property letting the world know there is a loan on the property and the original amount of the loan).

You can view our family services website for additional information on the types of services and other considerations legal counsel can assist with in a family transaction. (family services page linked here.)

What About Selling Below Fair Market Value or a Gift of Equity?

Selling to children below market value, including use of (and explanation of) a gift of equity, are addressed in our earlier article and video here (link here to our earlier article on selling below fair market value and use of a gift of equity).

Conclusion

Family loans are a great way to assist children or parents or relatives with real estate. Just ensure to properly document the loan and charge the applicable interest rate to avoid any confusion or penalties about a gift vs. a loan.

– Devin Lucas

Author Devin R. Lucas is a Real Estate Attorney, Broker and REALTOR®, specializing in Newport Beach, Costa Mesa and Orange County coastal communities, serving individual and investors in residential real estate.

Lucas Real Estate – Attorney Devin Lucas and CPA Courtney Lucas – are experts in residential real estate transactions, tax considerations, Trustee representation, family sales, and California’s Proposition 19.

Questions? – Paid one-hour confidential legal consultations are conducted daily via Zoom and address virtually all questions, options, tax implications and strategies. (Book a consultation here.)

Sources:

– See IRC Sec. 7872(a) & 7872(e) & 7872(f)(2)

– https://www.irs.gov/applicable-federal-rates

Photo by Kelly Sikkema on Unsplash

Lucas Real Estate
REALTORS® and related Real Estate Law & Tax Considerations
lucas-real-estate.com | [email protected] | BRE No. 01912302
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Newport Beach | California | 92663-4023Lucas Real Estate is a unique full-service residential real estate brokerage providing related residential real estate legal services and real estate tax considerations and planning, based in Newport Beach, California. | Devin Lucas is a licensed California Real Estate Attorney, Real Estate Broker and REALTOR® | Courtney Lucas is a California licensed CPA and REALTOR®

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