In this article:
In an intrafamily housing loan, an individual (usually a child or grandchild) finances a house using money lent by family members (typically parents or grandparents). The arrangement can save the borrower large sums and help the lender avoid estate taxes, but only if it's set up in accordance with IRS regulations.
What Are Intrafamily Loans?
An intrafamily housing loan is not, and cannot be, a casual arrangement. It must be a formal loan, set up carefully to avoid running afoul of tax laws. Both borrower and lender must stick to a repayment schedule, including applicable interest charges, to avoid having the loan construed as a gift, which can have major tax implications.
What Are the Elements of an Intrafamily Loan?
The following elements must be part of an intrafamily loan to be considered a loan and not a gift from family members by the IRS.
Set Loan Terms
For an intrafamily housing loan to be legitimate in the eyes of the IRS, it must be a formal loan with a fixed installment payment amount and a set repayment schedule. And in nearly all cases of intrafamily housing loans, interest rates must be charged.
While regular payments are essential, they need not follow the monthly payment schedule common to most traditional mortgages. If the borrower and lender prefer, payments may be due quarterly or even annually—an arrangement that often works well when the housing loan is used to transfer property for estate-planning purposes.
If an intrafamily housing loan exceeds the maximum amount the IRS allows for annual tax-free cash gifts to children or grandchildren, interest must be charged or the loan will be considered a taxable gift from the donor. The maximum allowable tax-free cash gift is $16,000 for 2022, or $32,000 if given by a couple that files taxes jointly; maximums for 2023 are $17,000 and $34,000, respectively.
Furthermore, interest must be charged at a rate equal to or greater than the current Applicable Federal Rate (AFR) at the time the loan is issued. Updated monthly, the AFR varies with the length of the loan's repayment period, in tiers for short-term loans (to be repaid within three years); medium-term loans (repaid in more than three years but no more than nine years); and long-term loans (repaid in more than nine years). Within each tier, rates are spelled out according to the interest-compounding period to be applied to the loan (annually, semiannually, quarterly or monthly).
As of November 2022, the AFR on a long-term loan with interest compounded monthly is 3.85%. That compares favorably with the 7.08% national average interest rate on a 30-year fixed-rate mortgage as of November 10, 2022, but it may seem steep compared with mortgages issued just a few years ago, before the Federal Reserve began raising rates to manage inflation.
Written Loan Contract
For an intrafamily housing loan to be legitimate in the eyes of the IRS, its terms must be set down in writing in the form of a promissory note or other formal contract. It must spell out the interest rate, repayment duration and monthly payment amount. A housing loan also should establish a lien against the house and spell out remedies, such as foreclosure, that can be pursued in the event of nonpayment.
The family member(s) issuing the loan will need to report interest they receive on the loan as income when submitting annual income returns. The recipient of the loan may deduct interest charges on the loan from their federal income tax return if they itemize their deductions.
When Are Intrafamily Loans a Good Idea?
If you're fortunate enough to have a parent or in-laws with the means to provide a home loan, or you have the means to do so for your own children or grandchildren, it's worth considering an intrafamily loan under any of the following circumstances:
- Interest rates are rising. In late October 2022, conventional mortgage rates rose above 7% for the first time in 20 years, and rates are expected to continue climbing (with occasional dips) as long as the Federal Reserve continues raising rates. Fed activity brings increases to the AFR as well, but that rate remains several points lower than those available from banks and credit unions, so a borrower using an intrafamily loan can save significantly over the life of the loan.
- The borrower can't qualify for a conventional mortgage. For would-be homebuyers with short credit histories or past missteps that have damaged their credit, a conventional mortgage may be inaccessible or prohibitively expensive. Intrafamily loan borrowers don't have to worry about credit checks or other financial scrutiny. It may be advisable for family members issuing intrafamily home loans to do some due diligence, however, particularly if they'll be counting on payments as part of their regular cash flow.
Borrowers needing to build credit should note that payments on intrafamily housing loans will not appear on their credit reports or benefit their credit scores the way on-time payments on a conventional mortgage would.
- The lender wishes to sidestep estate taxes. Intrafamily loans are popular tools for transferring wealth between generations in a way that avoids hefty estate taxes. One way this can work is for the family member(s) issuing the loan to give the borrower a tax-free gift each year, which the borrower then applies toward loan payments. If this strategy makes sense for your situation, keep in mind that the maximum allowable tax-free gift amount can change annually, and if that amount is insufficient to cover a full year's worth of payments, the borrower will have to pay the difference to keep the loan in good standing.
The Bottom Line
Intrafamily loans can provide a great opportunity for borrowers to save money and afford homes they couldn't finance through other means. They also can be a great tool for parents and grandparents seeking to transfer wealth to their children or grandchildren while avoiding estate taxes that would apply to traditional property bequests.
Because there are significant legal and tax considerations around intrafamily housing loans, it's highly advisable to consult an attorney or tax expert familiar with these matters to help ensure your loan is structured and documented in a way that will withstand IRS scrutiny—and that both parties to the loan report payment and interest information correctly on their federal tax returns.