Timely considerations for lending to adult children
A few weeks ago I had the opportunity to attend the Philadelphia Bar Probate and Trust Law Section Quarterly Meeting at what many of us know affectionately as the old Wanamaker’s Building.
Upstairs from Philadelphia’s Macy’s at 100 Penn Square East, educational programs are conducted at Pennsylvania Bar Institute headquarters and this one, like many others, was enlightening.
The timely subject was “What Estate Planners Should Do Or Undo In a Troubling Economy.”
It is true that some of the subjects are beyond the average client’s range of interest.
For instance, based on new annuity tables being issued, this may be a good time for GRAT’s and CLAT’s (Grantor Retained Annuity Trusts and Charitable Lead Annuity Trusts) but not so for QPRT’s (Qualified Personal Residence Trusts).
One subject that inspires more general common interest is “Creating and Refinancing Intra-Family Loans.” Translated, the subject was what are the positives and negatives legally and financially in lending to children and other relatives?
All things being equal, as the speaker pointed out, this could be a good time for intra-family loans since interest rates are low.
If a parent were making a sizeable loan to an adult daughter to pay off the daughter’s mortgage, for instance, in order for the loan not to be considered a gift, the parent needs to charge interest at least as high as the Applicable Federal Rate (AFR).
The AFR in June is 0.75 percent for short-term loans, 2.24 percent for medium-term loans and 3.84 percent for long-term loans. These are good rates for the borrower. If the child has difficulty in this market qualify
ing with a commercial lender, one alternative could be borrowing from a parent and paying back the loan over time with interest.
Readers would note that I used the expression “all things being equal.”
In my experience, all things are rarely equal. The most difficult problem that I have seen is that, when loans are made to family members, they are too often not repaid.
In addition, unpleasant feelings connected with collection can cause family rifts. Unfortunately, there is too great a temptation when other bills come due to view payments on a loan from Mom or Dad or from brothers and sisters as optional.
This is not always true so here are some considerations when deciding whether a loan transaction makes sense.
Can the Lender Afford To Lend? Sometimes parents who are strapped for cash lend to children even when it affects their own ability to survive. Funds should not be taken from those otherwise needed for a parent’s support and survival. This is especially true when there are modest means and health care needs. An unpaid loan could be considered a gift with penalties if a parent needs to qualify for Medicaid.
Are Both the Parent and the Child Willing To Follow Legal Formalities To Confirm That This Is a Loan and Not a Gift? A loan between parent and child, or between family members, if it is actually a loan and not a gift should look like a business loan with unrelated parties.
It should be in writing, describe the payment terms and schedule, contain default provisions, state the amount of interest, and, in the appropriate case, be secured by collateral. A loan might, for example, be secured by a mortgage on a borrower’s residence.
This last step is not just because the family member might default but, even if he is trustworthy, other unexpected events could occur. He could have other creditors, go through a divorce, or die without having paid back the debt. If the loan is in writing and especially if it is secured by collateral, it is less likely that the lender will be at risk.
Is the Borrower Credit Worthy? If the borrower has requested funds in the past that have remained unpaid, if he does not know how to handle money, and if he has been rejected by other lenders, this, of course, is a warning sign that the debt may not be repaid. In this case, pressure to lend should be resisted.
Is There a Strategy If the Loan Is Not Repaid? Sometimes parents forgive a loan on their death through instruments such as Self Cancelling Installment Notes (SCIN’s) or deduct the loan amount from the child’s inheritance. Before taking action, the lender should know any potential income tax consequences or, where sizeable loans are involved, any gift tax or estate tax consequences. For parents of more modest means, knowledge of Medicaid consequences is also critical.
About the Author Janet Colliton
Esquire, Colliton Law Associates, P.C. Janet Colliton has practiced law for over 38 years, 37 of them in Chester County, Pennsylvania, a suburb of Philadelphia. Her practice, Colliton Law Associates, PC, is limited to elder law, Medicaid, including advice, applications and appeals, and other benefits planning including Veterans benefits, life care and special needs planning, guardianships, retirement, and estate planning and administration.