Loans can be used to save transfer taxes. If parents loan money to children – or to grantor trusts for children – the loaned funds are not gifts, so long as the required interest rate is charged. To the extent the borrower earns more on investments made with the borrowed funds than the required interest rate, the difference passes gift tax-free from parents to children (or trusts for their benefit.
Required Interest – the Applicable Federal Rate
If interest is not charged on funds loaned by parents, the interest not charged is deemed a gift from parents to borrowers. IRS mandates the interest rate that must be charged each month. That rate is the applicable federal rate (“AFR”), and can be found easily on line at this IRS website: https://apps.irs.gov/app/picklist/list/federalRates.html.
The AFR is different depending on how long the loan is for. If the loan is less than three years, the “short-term” AFR is what needs to be charged. If the loan is for between three and nine years, the “mid-term” AFR is what needs to be charged. If the loan is for more than nine years, the “long-term” AFR is what needs to be charged.
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