What I Learned About Family Loans from Watching Gilmore Girls

Intra-Family Loans Can Serve as a Great Wealth Transfer Strategy 

Erin Itkoe, Senior Wealth Counselor

One of my all-time favorite TV shows is Gilmore Girls. When it first aired in the early 2000s, I was in college and enjoyed the witty dialogue, pop culture references, and the strong relationship between single mother Lorelai Gilmore and her teenage daughter, Rory. I recently re-watched the series and was struck by many wealth management planning aspects incorporated throughout the episodes.

In the very first episode, Rory gets accepted to Chilton, a prestigious private high school. Lorelai can’t afford the tuition, so she goes to her estranged parents and asks for a loan. They agree to pay for Rory’s school in exchange for weekly Friday night dinners. In the eyes of the IRS, this wouldn’t qualify as a legitimate intra-family loan, but the overall concept is there. The older generation helps the younger generation accomplish a goal, which requires financial resources. In exchange for the financial resources, the older generation receives something in return – in this case, the grandparents get to spend valuable time with their estranged daughter and granddaughter.

Intra-family loans are a great way for parents to help their children accomplish big milestones, such as buying a house or starting a business. These loans leverage parents’ assets, while at the same time, create a manner for children to have some skin in the game, which makes the whole experience more meaningful for the children.

An intra-family loan is similar to any other loan. One party loans funds to another party with the expectation that the funds (plus interest) will be returned within a set time period. For an intra-family loan, the interest rate cannot be lower than the Applicable Federal Rate (AFR), which the IRS publishes monthly. This is generally a favorable rate, making the intra-family loan very attractive.

Here are a few examples of intra-family loans:

  1. Buying a First House – when an adult “child” is looking to purchase their first home, they may not qualify for the most attractive mortgage because they lack a financial history. This could affect what house they can afford and/or are eligible for. With an intra-family loan, a parent can step in and serve as the bank. The 15-year or 30-year AFR may be significantly lower than the interest rate banks are offering, which may allow the child to purchase a more suitable house and possibly a better investment. Additionally, if the promissory note is secured by the house, they will still be able to deduct interest payments, which provides a great income tax benefit.
  2. Bridging the Gap Between Houses – very rarely does the timing of a sale of a house and the purchase of a new house work out perfectly. To secure the purchase of a new house, a strong offer (possibly all cash) may have to be made. If an adult child doesn’t have the financial resources readily available to make a strong offer, a parent can step in with a short-term intra-family loan, which bridges the gap between the two houses and allows the child to purchase their new dream house before the sale of the current house closes.
  3. Starting a New Business – similar to buying a first house, often times when an adult child is looking to start a new business, they may not qualify for the most attractive business loan due to lack of financial history. With an intra-family loan, a parent can step in and serve as the bank, often with a much lower interest rate. This provides the child with the necessary financial resources to flex their entrepreneurial muscles and start a business that they may not have otherwise been able to.
  4. Gifting Future Appreciation of Assets – a useful estate planning strategy is to gift assets during life of that which you think will have future appreciation. This removes the appreciation from your estate. An intra-family loan is an excellent tool to accomplish this goal because it allows you to keep your current estate intact while transferring the appreciation.

To avoid the IRS contesting an intra-family loan, a formal promissory note needs to be drafted and signed by all parties. The note must use an interest rate at least equal to the current AFR. A repayment schedule has to be created and timely payments made and documented.

Because intra-family loans are, in fact, loans, they don’t affect annual or lifetime gift exclusions. This creates an optimal opportunity for wealth transfer. For example, the lender can decide to forgive a portion (equal to the annual gift exclusion amount) of the promissory note each year. This won’t affect the validity of the promissory note or the lender’s lifetime gift exclusion, but it does create a great wealth transfer strategy that’s often more valued by the borrower because they already have money on the line.

About that Gilmore Girls and Chilton loan – the grandparents had the right idea when offering to pay for private high school. Instead of paying for it outright, they structured it as a “family loan,” which made it much more meaningful to both Lorelai and Rory, because they both then had skin in the game. At the end of the day, this was a great wealth transfer strategy, which, in this instance, also helped to repair an estranged relationship.

Intra-family loans are an ideal way to leverage parents’ assets (and possibly transfer wealth), while helping their children accomplish goals. I value them because they create a manner for children to be stakeholders, which makes the experience that much more meaningful. In the real world, intra-family loans are often forgiven over time, through gifting, and are never repaid, so it’s best to plan on not getting the funds back. Your Versant Capital Management Wealth Counselor is available to help guide you through the family loan process.

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