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 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: