#IDGT

By:  Henry VanBuskirk, CFP®, Wealth Manager

With all of the recent headlines in the news about mortgage rates increasing and waning home affordability, it seems daunting for the first-time home buyer.  A 30-year fixed mortgage now exceeds 7%, a level that hasn’t been seen since 2008. That same 30-year fixed mortgage was around 3% just a year ago. 

The reality here is that you aren’t going to be getting a 30-year fixed mortgage at 3% from your local bank anytime soon.  With that being said, there is one bank that might be willing to loan to you at a rate lower than 7% – The First National Bank of Mom and Dad.  What I’m talking about is an intra-family loan, which is a strategy that can be beneficial to both the borrower (a parent, family member, or family friend) and the lender.

Intra-Family Loan Basics

An intra-family loan is a formal agreement between a borrower and a lender.  Interest on the borrowed amount must be equal to or greater than predetermined IRS rates that are referred to as ‘Applicable Federal Rates’ (AFRs) and these rates are reset monthly.  Here’s the AFR for November 2022:

If we are using the mortgage example, we would want to assume a long-term AFR at a monthly rate (3.85% annually).  If we compare this to a mortgage rate of 7%, the AFR looks attractive to the borrower by comparison.  The key is that the lender must charge at least the AFR, because if they charge less than that, the IRS will impose their imputed interest rules.  Imputed interest is when the IRS believes that the loan is a gift and will instead report the difference between what the AFR is and what the lender charged and make the lender report that difference on the lender’s tax return.  As with anything involving the IRS, you want to make sure you are abiding by the rules they set forth and document that you are following those rules.

Consulting with a tax professional and legal professional is recommended before an intra-family loan arrangement is set up. The first step when drafting an intra-family loan is to make sure that you discuss the terms of the loan.  Then it is important to draft a promissory note, pledge collateral (i.e., the home), and send out monthly statements of the balance due.  We also recommend that an IRS Form 1098 be produced to the borrower for interest paid and an IRS Form 1099-INT be procured to the lender for interest received. 

Intra-Family Loan Example

For this example, assume that the borrowers are looking for a mortgage of $800,000 to help with their $1,000,000 home purchase and the bank quotes them a 30-year fixed rate mortgage at 6.5%.  Those same borrowers then look to mom and dad, and they are willing to set up an intra-family loan of $800,000 at a rate of 4.5% over 30 years.

Here is what an $800,000 30-year fixed-rate mortgage at 6.5% would amount to:

Now let’s look at the intra-family loan example for $800,000 over 30 years at 4.5% fixed:

The borrower would save $1,000 per month, every month, for 30 years and over $350,000 of interest over the life of the loan. 

Other Uses of Intra-Family Loans

Intra-family loans are not just a mortgage alternative.  An intra-family loan can also be set up to help the borrower start a small business.  It’s a similar argument for the mortgage example, the lender can loan to the borrower at a lower interest rate than the current prevailing interest rates. 

For reference, here are the current rates for small business loans from the Small Business Administration (SBA).

For this example, assume that the borrower wants to start a business and needs to borrow $100,000 to do so.  The SBA is willing to loan the $100,000 at a 9% interest rate over 10 years.  The borrower’s family member is willing to loan the $100,0000 at a 7% interest rate over 10 years.  Here is what the SBA loan details would look like:

Here’s what that same loan would look like at a 5% interest rate:

The borrower would in this example save $200 per month and over $24,000 in interest over the life of the loan by doing an intra-family loan.

What’s in it for the Lender?

So far all of this sounds great for the borrower, but what about the lender?  Fortunately, there are benefits to the lender as well. If the lender chooses, they could set up the intra-family loan to be forgiven at the lender’s death. Doing this would decrease the taxable estate of the lender because the heirs would not be required to continue paying the loan to your taxable estate. This means that if your estate is valued above the estate tax exemption and your estate is taxable, then your heirs would not be liable for the tax due on the remaining amount of the loan repayments. 

Furthermore, the loan payments can also be made to the lender, where the lender sets up a Trust where the lender is the owner for tax purposes, but not for estate tax purposes. This is called an Intentionally Defective Grantor Trust (IDGT).  Assuming that the IDGT is set up correctly, the income taxes would be paid by the lender (not the Trust), which would allow the periodic payments that are being sent to the Trust to grow tax-free.  When the lender dies, the assets in the IDGT won’t be included in the grantor’s taxable estate. The intra-family loan would need to be carefully constructed to account for these types of measures and it is recommended that you consult a legal professional. 

Another advantage is that if the lender thinks of the intra-family loan interest rate as an income stream to them, they would be receiving an income stream that isn’t tied to the stock or bond market.  This could further diversify their investment portfolio. Further, if the borrower turns out to not want to pay you back for whatever reason, the loan is collateralized by the home, small business, or whatever asset the borrower pledged to the lender and you could always just seize the asset that was put up as collateral. 

Summary

There are many different ways that an intra-family loan can help both the borrower and the lender achieve their long-term financial goals. We discussed some of these ways, including helping a first-time home buyer purchase a home, supporting a business-owner in starting a business, and how a lender can decrease the size of their estate with careful planning.  We are happy to discuss your long-term financial goals with you and help determine if an intra-family loan would be appropriate for your unique situation.

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s website or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please remember that different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy (including those undertaken or recommended by Company), will be profitable or equal any historical performance level(s). Please see important disclosure information here.

By:  Henry VanBuskirk, CFP®, Wealth Manager

(This is part 3 of a four-part estate planning series)

In part 2 of this series, we discussed strategic ways that you can get assets out of your estate. In this post, we would like to go over how you can capitalize on minimizing your estate tax, while your heirs enjoy the appreciated value of your asset, and how you are able to have some benefits of your own during your lifetime. This is sometimes referred to as an “estate freeze”.  Two estate freezing techniques that may be appropriate for your unique estate planning goals are utilizing an Intentionally Defective Grantor Trust (IDGT) and a Grantor Retained Annuity Trust (GRAT).  If you have concerns regarding how these strategies could affect certain estate and gift planning transactions in which you intend to engage or have previously engaged, please contact your tax advisor and estate planning attorney to further discuss your estate and gift planning inquiries. Our firm is happy to work with you and your estate planning attorney on your unique situation and we can work together to help you achieve your estate planning goals.

Intentionally Defective Grantor Trust (IDGT)

This irrevocable trust allows the grantor to continue paying income taxes on certain trust assets. Even though this sounds like a negative feature, this is what makes it “intentionally defective” and it has several benefits. This is because since the grantor must pay all taxes on all trust income annually, the assets in the trust can grow tax-free, and more importantly, avoid gift taxation for the beneficiaries of the trust.  Generally, it is best to sell assets to the IDGT because gifting assets to the IDGT could trigger gift taxes. Further, when assets are sold to an IDGT, there are no taxes owed because there is no capital gain recognized. Therefore, it is recommended that you take a highly appreciated asset (like a stock with a low-cost basis or shares of a family business) and sell it to the IDGT over a stated time (usually 10 years) in the form of an installment sale.  The goal of the IDGT is to have your heirs inherit the funds in the IDGT and gift those assets at the original value that the IDGT was funded at and lower your taxable estate.

Basics of an IDGT

IDGT example:  Mommy and Daddy Warbucks have an estate worth $100 million and are concerned about the size of their estate when it comes to what their heirs will inherit and what the estate tax bill will look like upon the Warbucks’ death. Part of their estate includes ABC stock that they bought for $100,000 that is now worth $10 million. Assume that the Warbucks’ sell the ABC stock to their newly formed IDGT over 10 years. After the end of the 10 years, the IDGT is fully funded with ABC stock. Now assume that for the next 10 years, the Warbucks’ IDGT appreciates to $20 million, their estate is now $110 million and then they pass away. During those 10 years that all shares of the ABC stock were in the IDGT, the Warbucks’ paid income tax on the dividends received, but did not pay any capital gains on any of the appreciation throughout the life of owning ABC stock. Further, they were able to gift their heirs $20 million of stock and receive a step up in cost basis. Additionally, they reduced the size of their estate when it comes to calculating tax liability to $90 million (instead of $110 million if they had not done an IDGT). As there are a lot of moving parts and due to an IDGT’s complexity, it is highly recommended that we work with you and an experienced attorney if an IDGT is recommended for your estate plan.

Grantor Retained Annuity Trust (GRAT)

A GRAT is an irrevocable trust that allows the grantor to fund the trust but retain the right to receive the original value of the assets contributed, while earning a rate of return specified by the IRS (referred to as the 7520 rate).  After a predetermined period, the beneficiary will be gifted the assets tax-free in the trust and the grantor will have to pay a gift tax on the original value of the GRAT. The grantor will still be on the hook for income taxes for income received during the term of the GRAT. If the grantor passes away before the term of the GRAT is up, then the value of the remainder interest is also included in the grantor’s estate.

Basics of a GRAT

Fun Fact – Mark Zuckerberg transferred $3,023,128 to his GRAT as Facebook went public in 2012.  He did this to help future generations in his estate receive the value of the stock when the GRAT term was up. When the GRAT term was up, the stock was valued at $37,315,513 and Mark was able to transfer that to his beneficiaries tax-free, while also being able to receive the original $3,023,128 after the term of the GRAT is up. Mark did have to pay income taxes on income received during the term of the GRAT and had a gift tax liability based on the original $3,023,128 at the end of the GRAT term, but as we learned from previous installments of this series, he would just utilize some of his married lifetime federal estate tax exemption of $24,120,000 to take care of the gift tax liability. Think what you will about Meta Platforms, Inc. (formerly known as Facebook), but Mark was able to legally lower his future tax bill with some careful planning that everyone has access to, not just the major CEOs of the world.

For the 4^th and final part of this estate planning series, we will cover the last planning pillar that we use when discussing estate planning – Gifting Assets from the Estate.

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s website or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please remember that different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy (including those undertaken or recommended by Company), will be profitable or equal any historical performance level(s). Please see important disclosure information here.