One way to reduce gift and estate taxes is to loan money to a family member who then buys an income-producing asset from the donor, repaying the loan with the income produced by the asset. So that the IRS does not treat it as a gift, the loan must charge a minimum interest rate, equal to the applicable federal rate (AFR) for the month in which the loan was originated and must be based on the term of the loan. The IRS considers a short-term loan to be any loan for up to 3 years; a midterm rate applies to loans ranging from 3 years to 9 years, and the long-term rate applies for any loans longer than that 9 years. The AFR is published monthly by the IRS as a Revenue Ruling, which can be found on its website.
To qualify as a bona fide loan, the loan should be evidenced by a note or other written instrument, charging an interest rate no less than the applicable AFR. There should be a fixed schedule for repayment and, for certain types of loans, where collateral is often used to secure payment, the same type of collateral should be used. So, if a donor sells real estate to his child, then the real estate should serve as collateral for the loan. To further support that the loan is not a gift, there should be a record of repayments.
Intrafamily loans can also be structured using a trust, where some funds are gifted to the trust to buy income-producing property from the grantor or other family member by using a loan for which the payments will be made from the income produced by the asset. As an alternative to funding the trust with seed money, a beneficiary could offer a personal guaranty for the loan or installment obligation.
For this to work, the asset must produce enough income to repay the loan. So, for instance, if you sell a condominium to your child at a market price of $50,000 and the renter pays $500 per month, then the term of the loan should be long enough so that the rental payment to cover the mortgage and expenses that landlords typically pay for that locality. Although the promissory note can be modified, some modifications, if they are large enough, may have some tax implications under Treasury Regulations §1.1001 – 3, that treats a significant modification as a sale or exchange of 2 instruments. Oftentimes, the major change is in the interest rate, where the cited regulation provides that the modification is significant if the yield exceeds the greater of: 0.25% or 5% of the annual yield of the unmodified instrument.
Another variation of the intrafamily loan is the installment sale, where an asset producing income is sold on an installment sale to be paid over a term of years. A requirement of the installment sale is that at least 1 payment is in a later tax year. Otherwise the sale would be reported in the current year. Marketable securities cannot be sold on the installment method. The installment method also cannot be used if the sale results in a loss to the seller. The installment sale treatment is also not allowed for sales of depreciable property to a controlled entity or to trusts benefiting the seller or the seller’s spouse. In these situations, all payments are treated as being received in the year of disposition.
When the sale is to a family member for which the seller wants to transfer the property, the installment sale can be structured as a Self-Canceling Installment Note (SCIN), where any debt remaining on the installment sale after the death of the seller is canceled, which is based on a provision in the installment agreement such as the following: “Upon the death of the seller, any debt due shall be deemed canceled and extinguished. The term of the SCIN must be less than the life expectancy of the seller to prevent it from being treated by the IRS is a private annuity.
Intrafamily loans and installment sales can also eliminate the generation-skipping transfer tax that would otherwise apply to gifts or bequests to a 2nd or younger generation of the donor.
Payments do not have to be made every year, or even in the 1st year. The installment sale can be structured that best befits the requirements of the seller and the buyer. However, any depreciation recapture or investment tax credit recapture must be reported in the year of the sale, even if no payments are made in the 1st year. Any payment of recaptured depreciation on an installment sale will increase the seller's basis by the amount of the recapture, thereby reducing or eliminating the gains that would be reportable when the installment payments are received.
To avoid the transaction being treated as a gift, the buyer should pay a premium for the cancellation-on-death provision. The SCIN payments should be should be sufficient so that the total actuarial present value of the payments equals the purchase price. Either the interest rate or the principal do can be increased to reflect the cancel-on-death provision. Higher interest rates may be deductible by the buyer, but a higher principal will allow greater depreciation if the property is depreciable.
An installment sale consists of 3 components: return of basis, gain, and interest. The seller must report gain and interest in any year in which payments are received. The gain portion of each payment is the same percentage of that payment as the total gain is in proportion to the total sales price. So if the total gain is 40% of the sale price, then 40% of each payment must be reported in the year that it is received as gain. The interest rate charged must be at least equal to the applicable AFR. Otherwise, the IRS will impute the interest rate for the transaction, along with penalties.
The interest paid by the buyer may be deductible if the installment sale was for investment property or trade or business. It may also be deductible as an itemized deduction for a qualified residence or 2nd residence of up to $1 million on acquisition indebtedness and $100,000 of home equity indebtedness.
With certain sales of land to family members, the AFR applies to any amounts exceeding $500,000; for loans with a lower principal, at least 6% compounded semiannually must be charged to avoid any imputed interest treatment.
If the seller dies before the end of the installment sale term, then the payments would be reported as income in respect of a decedent. The note for any installment sale will be included in the seller's estate, but any appreciation of the sold property will not be included. The transferee's basis in the installment sale asset will equal the fair market value on the date of the sale.
If the debt on an installment sale is canceled between related parties, then the seller must recognize gain, equal to the lesser of the fair market value on the date of cancellation or the face amount of the sales agreement minus the seller's basis in the obligation.