The Intra-Family Loan at the IRS-Published Rate That Saves a Couple $43,200 in Interest on Their Daughter’s $400,000 Home Purchase

When David and Linda Reynolds learned that their daughter Emily, and her husband, Brett, were struggling to buy a home, they wanted to help out. Emily and Brett had strong credit, stable jobs, and enough income to support a mortgage. The challenge was interest rates.

Mortgage rates have been averaging about 6.5% for 30-year loans. Combine that with elevated housing prices, and it’s no wonder Emily and Brett were struggling to afford a place of their own.

As the family discussed options, their financial advisor introduced them to a strategy that many people have never heard of. It’s called an intra-family mortgage using the IRS Applicable Federal Rate, or AFR. 

This approach allowed David and Linda to write Emily and Brett a loan that saved them tens of thousands of dollars over the life of their mortgage. It also made it possible for the couple to become homeowners rather than wait.

How the AFR created an opportunity

The IRS publishes monthly Applicable Federal Rates that establish the minimum interest rates that can be charged on loans between family members without triggering special tax consequences.

If family members try to loan each other money at very low interest rates, the IRS usually considers those loans a gift. That could be a problem if they exceed the annual gift tax exclusion.

Sticking to AFR guidelines allows families to write “clean” loans. The AFR is often a good one to two percentage points below market rates, so there can be big savings for those on the borrowing side. 

In Emily and Brett’s case, they needed $400,000 to purchase a home. By getting a less expensive loan, they’re able to save an estimated $43,200 over the course of repaying their mortgage over 30 years. 

That means their monthly payments will be lower. And by losing less money to interest, they’ll be able to improve their financial situation and save and invest more as they pay off their home.

The right documentation is crucial

When families give out loans, it’s important that those loans be documented officially to avoid problems. 

One of the most common mistakes in intra-family lending is treating the transaction like a casual agreement rather than a genuine loan. To avoid tax consequences, loans like the one Emily and Brett are receiving need to be written like an official promissory note. They should include the interest rate, repayment schedule, and other key terms.

If the loan is secured by the home, the family should also consider recording a mortgage or deed of trust against the property. That step also ensures that Emily and Brett can claim a mortgage interest deduction on their taxes. Meanwhile, David and Linda must report the interest they receive as taxable income.

It’s important to stick to the rules

If you’re in a strong financial position, it makes sense to want to offer a family member a very low-interest loan. But charging less than the IRS required rate could get you into trouble. 

However, if you stick to the AFR, you can potentially help a family member without triggering unwanted tax consequences. The key is to document everything carefully to avoid problems.