Interest-Only Long-Term Note
Family members often make loans to other family members for non-tax reasons. In a period of low interest rates, there may be tax reasons to make loans as well and, to maximize the tax benefits, the loan is most likely to be in exchange for an interest-only note for a term of years.
Why Use It?
When the lender has an estate that is likely to result in federal estate tax or state death taxes, an interest-only note can allow assets to be transferred to family members with no gift tax cost and with a reduced value for federal estate tax and state death tax purposes.
How Does It Work?
An intra-family loan may have income tax and gift tax consequences if the loan is not made with a market rate of interest. This is because section 7872 of the Internal Revenue Code imputes interest to "gift loans" that have a rate of interest that is less than the "applicable federal rate," which is the rate of interest that can be earned on federal securities with comparable terms.
However, a note paying interest at the applicable federal rate may have estate tax advantages, for the following reasons:
- The interest rate that may be applied to value the note for estate tax purposes may be higher than the interest payable on the note, in which case the future interest payments will be discounted and the fair market value of the note will be less than its face amount. The interest rates used to value the note at death may be higher than the interest rate payable on the note for at least two different reasons:
- Interest rates may have risen since the note was issued. (This is why making loans may be advantages during a time of lower than normal interest rates.)
- The applicable federal rate payable by under the note is a rate of interest paid by the federal government, which is an extremely highly rated borrower and so pays the lowest interest rates. The market rate of interest used to value the note should be a rate commonly paid on personal loans by individuals, which is typically a higher rate of interest. The value of the note may therefore discounted at death even though interest rates have not changed significantly.
- The estate tax value of the note may be further discounted due to lack of marketability and other factors.
- The borrower may have been able to invest the money represented by the note and earn more than is required to pay the interest on the note, resulting in a net profit. That net profit represents income that could have been earned by the borrower with that same money, and so the net profit has been effectively transferred from the borrower to the lender without any gift or estate tax.
The benefit of an interest-only note for a term of years is the possibility (but not certainty) that the note will be discounted to less than the face amount of the note at the death of the lender, and the possibility (but not certainty) that the borrower will be able to invest the loan amount and be able to earn investment income in excess of the interest payable on the note.
Because a promissory note is relatively easy to prepare, there are few transactional costs to making an interest-only loan.
The primary "costs" to the lender is a possible reduction in income if the interest payable on the note is less than the current investment income received by the lender on the amount of the loan, and the risk that the loan will not be repaid when it is due, or that the lender will need some of the funds for his or her own support before the note is due.
Before a interest-only loan is made, there are some decisions to consider:
- Are interest rates relatively low, and likely to rise in the future? The Internal Revenue Service usually announces the applicable federal rates for the following month around the 16th of the current month, so it may be advantageous to wait to make a loan until the end of the month, when the next month's rate will be known, to decide whether to make the loan using the current month's rates or the following month's rates.
- What should be the term of the loan? A loan of nine years or fewer can be made using the federal mid-term rate, which is typically less than the long-term rate, which applies to loans of more than nine years. A loan of fewer than nine years might therefore seem to be better because it can be at a lower rate, but it might be less certain how much interest rates will rise over the next nine years and, once the term of the note ends, so does any valuation benefit. So it might be better to "lock in" a slightly higher rate for a longer term.