Family members regularly transfer assets between one another. Transfers between spouses are so common that the IRS completely disregards them for transfer tax purposes. Most frequent are transfers between parent and child and grandparent and grandchild. If a parent transfers assets to a child and expects nothing in return, it is a gift, subject to gift tax or use of exemption. If a parent does not want to make a gift to her child, she can loan assets to the same child, and the transfer will not be subject to gift tax or use of exemption.

For a transfer to be respected as a loan rather than a gift, there must be an interest rate and an expectation of repayment. The IRS recognizes, however, that family members are willing to make loans to each other at lower interest rates than are standard for commercial transactions. These rates for “intra-family” loans are set by the IRS each month and change with other, more commercial interest rates. If a parent loans money to a child and charges no interest or interest at less than the IRS rate for that month, the “loan” can be recharacterized as a gift (subject to gift tax or use of exemption). If instead the parent engages her estate planning attorney to draft a simple loan document charging the applicable federal rate for the month the loan is made, there will be no gift, gift tax, or use of exemption.

Interest rates for this type of loan fluctuate with prevailing commercial rates. To put today’s rates in context, below is a chart showing historical rates for loans between family members and how they stack up against current rates.

We have included the hurdle rates for the same time periods, to the extent you are also contemplating grantor retained annuity trusts (GRATs).

These rates can be used to transfer assets from one family member to another transfer tax-free. For example, consider a client who took advantage of the low rates in January 2013. He loaned his daughter $2 million for eight years. The IRS considers this is a “mid-term” loan, so the child had to pay her parent 0.87% interest annually (see the red figures in the previous chart). This is a loan, not a gift, so the daughter also must pay back the full $2 million after eight years.

If the child invested the $2 million at Brown Brothers Harriman (BBH), in her own private business, or purchased real estate, as long as her investment grows at a rate greater than 0.87% before she has to pay it back, she is permitted to keep the appreciation transfer tax-free. If, for example, the $2 million enjoyed a 7% rate of return, the parent/client would have passed over $1 million to the child after eight years, transfer tax-free (see the nearby chart).

If the parent was feeling generous, he might decide to forgive some of the interest each year using his annual exclusion (currently $18,000 per year). If he was feeling especially generous, he might set up a GRAT for the benefit of the child, and she might in turn use any GRAT winnings to pay down the loan.

You may be wondering whether this type of intra-family loan strategy is appropriate in today’s higher interest rate environment. First, generally the rate on family loans is lower than the prevailing commercial rate, so if you know a family member does not have the liquidity they need, and the option is either borrowing from you or borrowing from a traditional lender, it is likely that the family loan will result in a lower rate for them.

In addition, interest payments “stay in the family” rather than going to a third-party institution.

Further, if rates decline, refinancing the note in a low interest rate environment would be a relatively painless way of reducing your estate and passing assets transfer tax-free to the borrower. The lower rate would mean less interest would be required to be paid back before the end of the note’s term. As long as there is some consideration for refinancing (that is, it is not just a gift from the lender to the borrower, but there is some reason to refinance – a longer loan term, or perhaps a partial prepayment), this strategy should not result in a gift tax or use of an exemption.

In the best-case scenario, these transactions are between the lender and a trust that is “grantor” to him or her for income tax purposes. For example, rather than the parent in the example above loaning his daughter $2 million directly, he would make the loan to a “grantor trust” that is written so that the daughter is a beneficiary of the trust. In this structure, the same impact is achieved, and there should be no income tax implications for interest payments/forgiveness between the parent and the trust for the benefit of the daughter.

Your estate planning attorney and BBH wealth planner can describe the nuances of this common strategy as well as grantor trusts in more detail.  If you would like to learn more, please contact your BBH relationship team.