Latest / The High Net Worth Podcast with Fexingo: Wealth Management, Tax Strategy, and Affluent Finance / How Wealthy Families Use Intrafamily Loans for Estate Planning
Transcript
- Lucas: So the lifetime gift and estate tax exemption is currently $13.61 million per individual, but that number is scheduled to drop to roughly $7 million on January 1, 2026. If you're a wealthy family looking to move assets out of your estate before that window closes, one of the most elegant tools is the intrafamily loan. Luna: Intrafamily loan — that's basically lending money to a child or a trust, right? But how does that help with estate taxes? Lucas: Exactly. The core idea: you lend a certain amount — say $5 million — to a trust for your children at the Applicable Federal Rate, which for July 2026 is around 3.4 percent for a mid-term loan. The trust then invests that money. If the investments earn, say, 8 percent, the 4.6 percent spread above the AFR accrues inside the trust, outside your estate. When the loan matures, the trust pays back the principal plus the 3.4 percent interest, and all the growth beyond that stays with the beneficiaries. Luna: So you freeze the value of the loan at the AFR, and the upside goes to the next generation without eating into your gift tax exemption? Lucas: Precisely. The loan itself isn't a gift — it's a loan. The only potential gift is if you charge below-market interest, but as long as you charge at least the AFR, there's no gift. And with the exemption set to drop, families are rushing to do these loans now, because once the money's out, it's out, even if your estate later exceeds the lower exemption. Luna: But don't you have to actually collect the interest? I've heard of parents forgiving the interest payments every year, which then counts as a gift. Lucas: Right, that's a common approach — you structure it so the interest is payable annually, and each year you gift the interest amount back to the trust. That gift uses your annual exclusion — currently $18,000 per person per year. So if the interest payment is $170,000 on a $5 million loan at 3.4 percent, you can gift $18,000 of it each year tax-free, and the remaining $152,000 uses part of your lifetime exemption. But the key is the principal never uses your exemption. Luna: So the strategy hinges on the trust actually earning more than the AFR. What if it doesn't? Say the trust invests conservatively and gets 2 percent — then you're stuck paying interest on a loan that's losing value. Lucas: That's the risk. You need an investment strategy that can outperform the AFR over the loan term. Most families use this for growth assets — a diversified equity portfolio, private equity, real estate. But if the trust underperforms, you still owe the interest. And if the trust can't pay, the parent can forgive the interest, but that triggers a gift. So it's not risk-free. Luna: And the IRS watches these closely. I've read that they can recharacterize an intrafamily loan as a gift if the documentation isn't perfect — like if there's no promissory note, no fixed repayment schedule, or if the borrower doesn't actually pay. Lucas: Absolutely. You need a written promissory note, a fixed interest rate at the AFR on the day the loan is made, a fixed maturity date, and actual payments — not just paper entries. The IRS has a whole set of rules under Section 7872. If they reclassify it, the entire loan amount becomes a gift, using up your exemption and potentially triggering gift tax. Luna: So what's the typical term? I've heard of demand loans, but those seem risky because the AFR can change. Lucas: Demand loans are variable-rate loans where the AFR is reset annually. The problem is if AFRs rise, your interest payments go up, and the spread narrows. Most planners recommend a term loan — fixed for the duration. The AFR is locked in on the day the loan is made. For a mid-term loan of three to nine years, the July 2026 AFR is 3.4 percent. If rates go to 6 percent, your loan stays at 3.4 — that's actually a benefit to the borrower. But if rates drop, you're stuck paying above-market, which hurts. Luna: So timing matters. Lock in when AFRs are low. And right now, 3.4 percent is historically low, but it's been lower — like under 1 percent in 2021. Lucas: Exactly. In 2021, the mid-term AFR was around 0.9 percent. Families who did loans then are sitting on huge spreads. If they invested in the S&P 500, which returned roughly 28 percent in 2021 and then negative 18 percent in 2022, but by now the cumulative return since 2021 is still well above 0.9 percent. So those loans have been very successful. Luna: Let's talk about the sunset. The Tax Cuts and Jobs Act doubled the exemption through 2025, but starting in 2026 it halves. For a wealthy couple, that's going from $27.22 million to about $14 million combined. If your estate is worth $20 million, you'd be over the new limit by $6 million, which would be taxed at 40 percent — that's $2.4 million in estate tax. Lucas: Right. So if you can move $5 million out of your estate now via an intrafamily loan, you're essentially saving $2 million in potential estate taxes — assuming your estate exceeds the new exemption. And you haven't used any of your gift exemption for the principal. Luna: But what if you want to move more than $5 million? Are there limits? Lucas: Not really — you can lend any amount, but the larger the loan, the more scrutiny from the IRS. Also, the borrower — the trust — needs to have enough assets to pay the interest, or the parent needs to gift the interest. If the loan is too large relative to the borrower's net worth, the IRS might argue it's really a gift. There's a concept of 'adequate security' — the trust should have collateral or a guarantee to support the loan. Luna: So you need a trust with some existing assets. That's often a problem for younger families who haven't already funded a trust. Lucas: Yes, that's a classic chicken and egg. One solution is to make a small initial gift to the trust to seed it — say $100,000 — so it has some capital. Then you do the loan. That gift uses your exemption, but it's a small price to pay for the ability to lend millions. Luna: Another strategy: combine an intrafamily loan with a grantor retained annuity trust, or GRAT. You can lend to a GRAT, and the GRAT's annuity payments go back to the grantor, effectively reducing the loan balance over time. Lucas: That's a more advanced structure. A GRAT itself is a way to transfer appreciation without gift tax, but if you layer a loan on top, you can get even more leverage. But it's complex — you need a good estate planning attorney and a CPA who handles these. Luna: And let's not forget state estate taxes. Some states have their own exemptions far below the federal level — like Massachusetts at $1 million, or Oregon at $1 million. For families in those states, the loan strategy can help even if they're under the federal sunset. Lucas: Good point. State estate taxes often have no portability and lower exemptions. So moving assets out via a loan can save state estate tax too, which in some states is as high as 16 percent. Luna: One thing I'm always curious about: what happens if the borrower — the child or trust — defaults? Can the parent just say 'don't worry about it'? Lucas: If the borrower defaults and the parent doesn't enforce the loan, the IRS can treat the unpaid amount as a gift. So you have to actually enforce it. That means the trust has to pay, or the parent has to formally forgive the debt — which is a gift. If the trust is structured as a grantor trust, the parent is considered the owner for income tax purposes, so interest payments are ignored for income tax — but the gift issue remains. Luna: So the parent is effectively taxing themselves on the interest? Because in a grantor trust, the parent pays the income tax on the trust's earnings, which further reduces their estate. Lucas: Exactly. That's actually a feature, not a bug. By paying the trust's income taxes, the parent is making an additional tax-free gift to the trust — it doesn't count as a gift for gift tax purposes. So the trust grows even faster. It's one of the reasons grantor trusts are so popular in estate planning. Luna: Let's bring this down to a concrete example. Say a couple, both 60, have an estate worth $20 million. They do a $5 million mid-term loan to a grantor trust for their children at 3.4 percent for five years. The trust invests in a diversified portfolio earning 7 percent. After five years, the trust owes $5 million principal plus about $850,000 in interest. But the portfolio grew to roughly $7 million — call it $7 million after some volatility. So the trust pays back $5.85 million, leaving $1.15 million in the trust, free of estate tax. That's a $1.15 million transfer using no gift exemption on the principal, and the only gift is the interest payments they might forgive. Lucas: That's a solid illustration. And if they had done nothing, that $1.15 million would be part of their estate and potentially taxed at 40 percent. So they've saved $460,000 in estate tax, plus the growth on that $1.15 million going forward is also outside the estate. And they can repeat the strategy with a new loan after the first one matures. Luna: But what if the AFR goes up in five years? A new loan would have a higher rate, so the spread might shrink. Lucas: That's a risk, but you can also make a longer-term loan — say 15 years, where the current AFR is 4.2 percent. That locks in a lower rate for longer, but you're committing to the interest for 15 years. With the mid-term, you have flexibility to refinance if rates drop — but you'd need a new loan and pay off the old one. Luna: So there's a trade-off between locking in a low rate and having flexibility. For families expecting rates to stay low or fall, a longer term might make sense. If they think rates will rise, a shorter term is better. Lucas: Exactly. And you have to consider your overall estate plan. These loans work best when combined with other strategies — like using the annual gift exclusion to pay the interest, or pairing with a GRAT for larger transfers. They're not a standalone solution. Luna: Before we wrap up, I want to mention something practical. A listener might think, 'I can just lend my kid money informally.' But the IRS requires a written agreement, and you must charge interest. Many families use a standard promissory note with the AFR rate from the IRS monthly rate sheet. And you need to actually report the interest income on your tax return — even if you forgive it. Lucas: Yes, and that's a common mistake. If you don't report the interest, you're inviting an audit. The IRS matches 1099 forms. So work with a CPA who understands these rules. It's not a DIY project. Luna: You know, talking about all this planning, if our conversations have helped you think about your own estate or investment strategy differently, there's a small way to support the show. It's at buy me a coffee dot com slash fexingo. That's one word — fexingo. No pressure, but it helps us keep the podcast ad-free and focused on practical strategies like these. Lucas: Yeah, and every bit of support goes directly into research and better guests. But back to the loans — one last nuance. If you're thinking about doing an intrafamily loan before the 2026 sunset, don't wait until December. The IRS requires the loan to be in place and funded before the end of the year. And with year-end legal fees surging, you're better off starting now, in July. Luna: Good advice. So to sum up: intrafamily loans are a powerful way to freeze the value of a portion of your estate, transfer future appreciation to the next generation, and preserve your gift tax exemption for other needs. But they require careful documentation, a realistic investment plan, and professional guidance. Lucas: Absolutely. And with the exemption sunset looming, this is one of the most actionable tools out there. If you're a high-net-worth family, it's worth a conversation with your estate attorney. For our listeners, thanks for tuning in — we'll be back next episode with another strategy.