December 2008 Welcome to the Bank of Mom and DadHelp relatives with loans, but protect the principalLending is a great way for you to help your family and possibly garner a greater return on your money than by investing it in a CD or money market account. Still, many people never approach the subject of lending because they find it awkward to discuss money with family. But it doesn't have to be that way. The Family LoanWith the nation's credit crisis and failing capital markets, the appeal of a family loan is evident. Low interest family loans benefit recipients and are a significant estate planning tool for families. The classic example is Mom and Dad loaning money to a child who is buying his or her first home. Instead of gifting the money, Mom and Dad loan a down payment or the entire purchase price. If the home is valued above $12,000, which most are even in this market, anything above that mark can be considered a gift and be taxed. To avoid triggering a gift tax, you can provide a low interest loan based on the Applicable Federal Rate (AFR), which the government determines monthly. It's typically less than a bank rate. In August 2008, the average rate on a 30-year mortgage was 6.5%, but the AFR was between 2.5% and 4.5%. (For current AFR information, visit the IRS website.) A New HouseMom and Dad loan $400,000 to a son and daughter-in-law at an AFR of 3%. At the end of the year, Mom and Dad then gift $24,000 to their son, who applies it to the principal of the mortgage. This allows Mom and Dad to avoid a gift tax and enables their son to save a substantial sum. The stunning advantage of this strategy is that while the child saves hundreds of thousands of dollars in interest that he or she would pay to a bank, Mom and Dad receive a higher rate of return than from a CD or a money market account. The InvestmentIn another scenario, the borrower can take the loan and invest it at a higher rate of return than the loan itself. At the end of the loan, you receive the principal back and have essentially transferred the amount of the investment's increase to your child, free of a gift tax. Be sure to treat the loan like a formal business arrangement and be willing to enforce any legal claims against a defaulting borrower. If borrowers stop making payments, then you can find yourself in the regrettable position of having to foreclose on your own children. This downside seems remote, but it is one that you must consider. If you can live with this resolve, then this can be a powerful, winning strategy for everyone.
Adapted from the Daily Plan-It newsletter Hoopes, Adams & Alexander, PLC, is a Chandler, Arizona, law firm offering services to Phoenix-area clients in the areas of estate planning, entity formation, commercial and real estate transactions, and civil litigation. | 
